Part 4 Technical Analysis – Using Trend Lines

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Trend Lines

Table of Contents

Trend Lines

As technical analysis is built on the assumption that prices trend, the use of trend lines is important for both trend identification and confirmation. A trend line is a straight line that connects two or more price points and then extends into the future to act as a line of support or resistance. Many of the principles applicable to support and resistance levels can be applied to trend lines as well. It is important that you understand all of the concepts presented in our Support and Resistance article before continuing on.

Definition

Uptrend Line

An uptrend line has a positive slope and is formed by connecting two or more low points. The second low must be higher than the first for the line to have a positive slope. Note that at least three points must be connected before the line is considered to be a valid trend line.

Uptrend lines act as support and indicate that net-demand (demand less supply) is increasing even as the price rises. A rising price combined with increasing demand is very bullish, and shows a strong determination on the part of the buyers. As long as prices remain above the trend line, the uptrend is considered solid and intact. A break below the uptrend line indicates that net-demand has weakened and a change in trend could be imminent.

Downtrend Line

A downtrend line has a negative slope and is formed by connecting two or more high points. The second high must be lower than the first for the line to have a negative slope. Note that at least three points must be connected before the line is considered to be a valid trend line.

Downtrend lines act as resistance, and indicate that net-supply (supply less demand) is increasing even as the price declines. A declining price combined with increasing supply is very bearish, and shows the strong resolve of the sellers. As long as prices remain below the downtrend line, the downtrend is solid and intact. A break above the downtrend line indicates that net-supply is decreasing and that a change of trend could be imminent.

For a detailed explanation of trend changes, which are different than just trend line breaks, please see our article on the Dow Theory.

Scale Settings

High points and low points appear to line up better for trend lines when prices are displayed using a semi-log scale. This is especially true when long-term trend lines are being drawn or when there is a large change in price. Most charting programs allow users to set the scale as arithmetic or semi-log. An arithmetic scale displays incremental values (5,10,15,20,25,30) evenly as they move up the y-axis. A $10 movement in price will look the same from $10 to $20 or from $100 to $110. A semi-log scale displays incremental values in percentage terms as they move up the y-axis. A move from $10 to $20 is a 100% gain, and would appear to be much larger than a move from $100 to $110, which is only a 10% gain.

In the case of Amazon.com (AMZN), there were two false breaks above the downtrend line as the stock declined during 2000 and 2001. These false breakouts could have led to premature buying as the stock continued to decline after each one. The stock lost 60% of its value three times over a two-year period. The semi-log scale reflects the percentage loss evenly, and the downtrend line was never broken.

In the case of EMC, there was a large price change over a long period of time. While there were not any false breaks below the uptrend line on the arithmetic scale, the rate of ascent appears smoother on the semi-log scale. EMC doubled three times in less than two years. On the semi-log scale, the trend line fits all the way up. On the arithmetic scale, three different trend lines were required to keep pace with the advance.

Validation

It takes two or more points to draw a trend line. The more points used to draw the trend line, the more validity attached to the support or resistance level represented by the trend line. It can sometimes be difficult to find more than 2 points from which to construct a trend line. Even though trend lines are an important aspect of technical analysis, it is not always possible to draw trend lines on every price chart. Sometimes the lows or highs just don’t match up, and it is best not to force the issue. The general rule in technical analysis is that it takes two points to draw a trend line and the third point confirms the validity.

The chart of Microsoft (MSFT) shows an uptrend line that has been touched 4 times. After the third touch in Nov-99, the trend line was considered a valid line of support. Now that the stock has bounced off of this level a fourth time, the soundness of the support level is enhanced even more. As long as the stock remains above the trend line (support), the trend will remain in control of the bulls. A break below would signal that net-supply was increasing and that a change in trend could be imminent.

Spacing of Points

The lows used to form an uptrend line and the highs used to form a downtrend line should not be too far apart, or too close together. The most suitable distance apart will depend on the timeframe, the degree of price movement, and personal preferences. If the lows (highs) are too close together, the validity of the reaction low (high) may be in question. If the lows are too far apart, the relationship between the two points could be suspect. An ideal trend line is made up of relatively evenly spaced lows (or highs). The trend line in the above MSFT example represents well-spaced low points.

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On the Wal-Mart (WMT) example, the second high point appears to be too close to the first high point for a valid trend line; however, it would be feasible to draw a trend line beginning at point 2 and extending down to the February reaction high.

Angles

As the steepness of a trend line increases, the validity of the support or resistance level decreases. A steep trend line results from a sharp advance (or decline) over a brief period of time. The angle of a trend line created from such sharp moves is unlikely to offer a meaningful support or resistance level. Even if the trend line is formed with three seemingly valid points, attempting to play a trend line break or to use the support and resistance level established it will often prove difficult.

The trend line for Yahoo! (YHOO) was touched four times over a 5-month period. The spacing between the points appears OK, but the steepness of the trend line is unsustainable, and the price is more likely than not to drop below the trend line. However, trying to time this drop or make a play after the trend line is broken is a difficult task. The amount of data displayed and the size of the chart can also affect the angle of a trend line. When assessing the validity and sustainability of a trend line, keep in mind that short and wide charts are less likely to have steep trend lines than long and narrow charts.

Internal Trend Lines

Sometimes there appears to be the possibility of drawing a trend line, but the exact points do not match up cleanly. The highs or lows might be out of whack, the angle might be too steep or the points might be too close together. If one or two points could be ignored, then a fitted trend line could be formed. With the volatility present in the market, prices can over-react, producing spikes that distort the highs and lows. One method for dealing with over-reactions is to draw internal trend lines, which ignore these price spikes to a reasonable degree.

The long-term trend line for the S&P 500 ($SPX) extends up from the end of 1994, and passes through low points in Jul-96, Sept-98 and Oct-98. These lows were formed with selling climaxes, and represented extreme price movements that protrude beneath the trend line. By drawing the trend line through the lows, the line appears to be at a reasonable angle, and the other lows match up extremely well.

Sometimes, there is a price cluster with a high or low spike sticking out. A price cluster is an area where prices are grouped within a tight range over a period of time. The price cluster can be used to draw the trend line, and the spike can be ignored. The Coca Cola (KO) chart shows an internal trend line that is formed by ignoring price spikes and using the price clusters, instead. In October and November 1998, Coke formed a peak, with the November peak just higher than the October peak (red arrow). If the November peak had been used to draw a trend line, then the slope would have been more negative, and there would have appeared to be a breakout in Dec-98 (gray line). However, this would have only been a two-point trend line, because the May-June highs are too close together (black arrows). Once the Dec-99 peak formed (green arrow), it would have been possible to draw an internal trend line based on the price clusters around the Oct/Nov-98 and the Dec-99 peaks (blue line). This trend line is based on three solid touches, and it accurately forecasts resistance in Jan-00 (blue arrow).

Conclusion

Trend lines can offer great insight, but, if used improperly, can also produce false signals. Other items – such as horizontal support and resistance levels or peak-and-trough analysis – should be employed to validate trend line breaks.

While trend lines have become a very popular aspect of technical analysis, they are merely one tool for establishing, analyzing, and confirming a trend. The uptrend line for VeriSign (VRSN) was touched 4 times and seemed to be a valid support level. Even though the trend line was broken in Jan-00, the previous reaction low held and did not confirm the trend line break. In addition, the stock recorded a new higher high prior to the trend line break.

Trend line breaks should not be the final arbiter, but should serve merely as a warning that a change in trend may be imminent. By using trend line breaks for warnings, investors and traders can pay closer attention to other confirming signals for a potential change in trend.

How to Draw Trend Lines Perfectly Every Time [2020 Update]

Trend lines have become widely popular as a way to identify possible support or resistance. But one question still lingers among Forex traders – how to draw trend lines?

In this lesson, we’ll discuss what trend lines are as well as how to draw them. I’m also going to share a secret way that I like to use trend lines to spot potential tops and bottoms in a market, so be sure to read the lesson in its entirety.

What Are Trend Lines?

As the name implies, trend lines are levels used in technical analysis that can be drawn along a trend to represent either support or resistance, depending on the direction of the trend. Think of them as the diagonal equivalent of horizontal support and resistance.

Exclusive Bonus: Download the trend lines PDF cheat sheet to learn helpful tips and techniques on how to draw these levels and use them to find setups.

These trend lines can help us to identify potential areas of increased supply and demand, which can cause the market to move down or up respectively.

Let’s take a look at a trend line that was drawn during an uptrend.

Notice how in the GBPUSD daily chart above, the market touched off of trend line support several times over an extended period of time. This trend line represented an area of support where traders can begin to look for buying opportunities.

Now let’s take a look at a trend line that was drawn during a downtrend.

Similar to the GBPUSD uptrend in the first chart, this AUDNZD downtrend touched off of our trend line several times over an extended period of time. The difference is that the trend line above represents a downtrend, during which time it acts as resistance, giving traders an opportunity to look for selling opportunities.

How to Draw Trend Lines Correctly

Now that we have a good understanding of what trend lines are, let’s go over how to draw them.

The very first thing to know about drawing trend lines is that you need at least two points in the market to start a trend line. Once the second swing high or low has been identified, you can draw your trend line.

Here is an example of the first two swing lows that have been identified.

Notice in the chart above, we have two main points at which we can start to draw our trend line. Once this level has been established, we can start to look for bullish price action to join the rally.

Sure enough, just a few weeks later a bullish pin bar emerged at trend line support.

The bullish pin bar above provided a signal to traders that the trend line was likely to hold. This gave traders an opportunity to buy at support to join the rally.

3 Keys to Drawing Trend Lines Effectively

There are three very important keys to drawing effective trend lines.

  • The higher time frames will always produce the most reliable trend lines, so start there and work your way down
  • Most trend lines you come across will have some overlap from the high or low of a candle, but what’s important is getting the most touches possible without cutting through the body of a candle
  • Never try to force a trend line to fit – if it doesn’t fit the chart then it isn’t valid and is therefore not worth having on your chart

Let’s take a look at each of these in greater detail.

Use the Higher Time Frames for Drawing Trend Lines

Just about everything I do in the Forex market begins on the daily time frame and drawing trend lines is no exception. One reason I prefer the daily time frame for drawing trend lines, besides the fact that I do most of my trading from this time frame, is that it represents an extended period of time.

This brings me to a very important rule regarding trend lines. The longer a trend line is respected, the more important it becomes. A trend line that extends over two years will always be considered more important than a level that only extends the course of two weeks.

Here is a great example of a trend line that was drawn from the daily time frame.

In the GBPCHF daily chart above, after the second swing low was made we could have drawn our trend line. Notice how the market formed a bullish pin bar at the third touch from this trend line. This is a perfect example of the type of buying opportunity a trader would look for using trend line support.

Another higher time frame that I like to use to draw trend lines is the weekly chart. This time frame is great for identifying potential targets during uptrends or downtrends on the daily time frame.

Here is a great example of how a weekly trend line on CADCHF can be used to identify a potential target.

The chart above shows a weekly trend line that can be extremely useful to identify a potential target for CADCHF. The daily time frame is in an uptrend at the moment, so this weekly trend line would give us a great starting place to look for a potential profit target.

Trend Lines and Overlap

One of the most common questions when it comes to drawing trend lines is, should they be drawn from the high/low of a candle or from the open/close of the candle. The answer to this question depends on the trend line.

It’s very rare to find a trend line that lines up perfectly with highs or lows. Similarly, it’s rare to find a trend line that lines up perfectly with the open or close of each candle.

Let’s take a look at an example

Notice how the trend line above does not perfectly line up with the highs of each candle, nor does it line up perfectly with the open or close of each candle. This doesn’t mean that the trend line is invalid. What’s important here is that the weekly chart above never closed above this level.

The most important part of any trend line is to get the most touches without the level cutting off part of a candlestick. If you find that a trend line cuts through the body of a candlestick, then the trend line is likely not valid.

Never Try to Force a Trend Line to Fit

This is perhaps the most common pitfall Forex traders make when drawing trend lines. We call this “curve fitting” and it happens when a technical trader is so convinced that a level should exit, that the trader begins to try to make the level fit the price action on the chart.

This brings me to the most important part about drawing trend lines, or any support or resistance level for that matter. The best trend lines are the most obvious ones. So if a trend line doesn’t fit well, it’s probably best to move on to another pattern.

How to Use Trend Lines to Spot Potential Reversals

As promised, I’m going to show you a way that I like to use trend lines to determine the strength of a trend. Moreover, this method can help you spot potential reversal points in the market.

At this point in the lesson, you know that a trend line can be used to identify potential buying or selling opportunities. But this only works as long as the market continues to respect the trend line as support or resistance. So what happens when the market no longer respects the level?

This is where you have a chance to trade a market as it makes a turn from a major swing high or low. Below is an example of a market that broke trend line support and then retested that same trend line as new resistance.

We can see in the GBPCHF daily chart above, that the pair had respected a trend line for some time. However once the market broke trend line support, it quickly retested former support as new resistance. This retest gave traders the opportunity to sell the pair, which would have resulted in a substantial gain over the next several days as the market sold off.

One thing to note about using trend lines in this way is that it works best when you have a really clean trend line with three or more touches. The more obvious the trend line is, the better this strategy will work.

We can also use this strategy to identify a bullish reversal.

Notice how shortly after breaking trend line resistance, the market came back to retest the trend line as new support and formed a bullish pin bar in the process. This gave price action traders an opportunity to buy just before the market rallied for 800 pips.

This is a great way to use trend lines to spot potential reversals in the market. It is without a doubt one of the best ways to catch a big move as a market changes direction.

Summary

I hope this lesson has given you a better understanding of how to draw trend lines and how they can be used in the Forex market.

We’ve covered a lot in this lesson, so let’s recap some of the important points.

  • Think of trend lines as the diagonal equivalent to horizontal support and resistance levels
  • Trend lines can help traders identify buying and selling opportunities that occur within a strong trend
  • The higher time frames will always produce the most reliable trend lines, so start there and work your way down
  • Most trend lines you come across will have some overlap from the high or low of a candle, but what’s important is getting the most touches possible without cutting through the body of a candle
  • Never try to force a trend line to fit – if it doesn’t fit the chart then it isn’t valid and is therefore not worth having on your chart
  • A break and retest of a trend line that had three of more touches can often mean a reversal in the market and a potential buying or selling opportunity

General FAQ

A trend line is a diagonal support or resistance level on a price chart. It’s often used to identify support during an uptrend or resistance during a downtrend.

Start with a prominent high or low on a higher time frame such as the daily. From there, look to see if you can connect a trend line with the subsequent lows (for an uptrend) or highs (for a downtrend).

It’s okay if a trend line cuts through a small part of the upper or lower wick on a candlestick. However, as a general rule, a trend line should not cut through the body of a candlestick.

Now I’ve Got a Question For You.

Are you ready to begin using these techniques in your trading?

Then you definitely want to download the free Forex trend lines PDF that I just put together.

It contains the four keys to drawing these levels accurately. I’ve also included examples so you can see exactly how I use trend lines in my trading.

Click the link below and enter your email to download the cheat sheet.

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Trend Lines

Trend lines are one of the most basic concepts of day trading (and long term investing), and they are also one of the most powerful concepts. Trend lines have been used for trading for as long as there have been markets, and they are well suited to any type of market (stocks, currencies, commodity futures, etc.). Trend lines are based upon the idea that markets move in trends (sustained movement in one direction, and then sustained movement in the opposite direction). Trend lines show the general direction of the price movement (upwards, downwards, or sideways), the strength of the current price movement, and where future support and resistance are likely to be located. In addition to being drawn on price charts (usually bar or candlestick charts), trend lines can be drawn on indicator charts (such as the CCI, TRIX, RSI, etc.), where they show the same information, but are based upon the indicator’s values instead of the prices.

What are Trend Lines?

Trend lines show three distinct but related pieces of information about their market. They show the direction of the current price movement, the strength (or more precisely the speed) of the current price movement, and the future support and resistance of the current price movement. These pieces of information can be used independently of each other, or they can be used together as part of a larger trading system. Each of these valuable pieces of information are described in detail in the following articles :

  • Direction of Price Movement
  • Strength of Price Movement
  • Support and Resistance

Drawing Trend Lines

Trend lines are straight lines that are drawn on graphical price or indicator charts. Upward trend lines are drawn on an upward diagonal from left to right (/), downward trend lines are drawn on a downward diagonal from left to right (\), and sideways trend lines are drawn horizontally from left to right (-). The following tutorials explain how to draw each type of trend line :

  • Drawing Upward Trend Lines
  • Drawing Downward Trend Lines
  • Drawing Sideways Trend Lines

Trading with Trend Lines

There are many different ways of trading using trend lines, but two of the oldest ways are trend line bounces and trend line breaks. Trend line bounces are trend continuation trades, because they expect the price to touch the trend line and then reverse back to its original direction. Conversely, trend line breaks are trend reversal trades, because they expect the price to go through the trend line and then continue in its new direction. Even though they are opposite trades, both trend line bounces and trend line breaks are based upon trend lines being support and resistance, so many day traders trade both of these trades. The following tutorials describe trend line bounces and trend line breaks in detail :

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