Technical Analysis: Trendlines
Overview
This module delves deeper into technical analysis and focuses specifically on trendlines, and how they prove useful to the trader.
There are many topics in technical analysis that you can study and this module is one of many examples that you can look into.
Defining Trendlines
Trend lines are lines that are drawn at an angle above or below the price. They provide indications about the immediate trend and show when a trend has changed. They can also function as support and resistance and offer opportunities to open and close positions.
The Trend is Your Friend
The supply and demand balance establishes a trend. A trend indicates that there exists an inequality between the forces of supply and demand. The notion of trend is extremely critical to the technical approach. The intention behind charting the price action is to pinpoint trends in the initial stages of their development for the objective of trading in the direction of those trends. There is an effect to the premise that prices move in trends – a trend in motion is more likely to continue than to reverse. This effect is, of course, an adaptation of Newton’s first law of motion. Another way to state this effect is that a trend in motion will continue until it reverses.
Long-term trends can be interrupted by corrective short-term trends before continuing within the long-term channel, or market action can move sideways and create patterns or congestion areas between levels of resistance and levels of support as a process of distribution (supply) and accumulation (demand) takes place at these levels respectively.
These patterns can be continuation patterns as prices move from one box (or pattern) to a higher box, more frequently found in bull markets, or to a lower box, more frequently found in bear markets.
The patterns can be reversal patterns, as supply overcomes demand and finally breaks a long-term trend.
It is important to understand that trends and patterns are people trends and patterns based on crowd psychology. In other words, it is very important to understand that technical analysis is a behavioural science and a good psychologist would probably be more successful as a technical analyst, as an expert on personal behaviour and emotions, and on crowd behaviour and the herd instinct.
In human nature it is a known and documented fact that people in a crowd soon lose their individuality creating a herd instinct, and conforms to their environment, which causes them to move in a more predictable manner.
Human nature is such that it tends to react to similar situations in consistent ways. As a rule, people will act in the same way as they have in the past.
The idea of trend is very important to the technical approach to market analysis. All the tools used by the chartist – support and resistance levels, price patterns, moving averages, trendlines etc. – have the single goal of assisting with measuring the trend of the market for the aim of participating in that trend. We often hear expressions such as “the trend is your friend,” “never buck the trend.” This ability of price to cling extremely close to a straight line is one of the most extraordinary characteristics of chart movements. Another important characteristic is that when a share is found to be following a given trend line, it is more likely to continue moving along that line, than not to.
Drawing Trendlines
It is perhaps obvious that the longer a share has been moving along a given trend or within a given channel, the stronger that trend is likely to be. For this reason, trendlines on longer-range charts such as weekly or monthly bar charts are usually more reliable than trendlines that form on intraday or daily bar charts.
Even when shares break away from an established trendline and signal a true shift in direction, they have a tendency to return to it. This magnetic attraction of the old trend is called a “pull-back” effect and is common to trendlines. Prices move in a series of peaks and troughs and the direction of these peaks and troughs determine the trend.
An uptrend is a continuous series of higher “highs” and higher “lows” and is drawn by connecting the lower points of a share movement line (A-G). Another feature of trendlines on bar charts is that a parallel line (B-H) often develops and produces a well-defined “channel”.
When a sideways trend forms, both upper and lower points often conform to parallel, straight horizontal lines. This type of sideways action reflects a period of equilibrium in the price level where the forces of supply (B & D) and demand (A & C) are in a state of relative balance.
It is essential to have a solid grasp of the concepts of support and resistance in order to fully understand the concept of trend. For an uptrend to continue, each successive low (support level) must be higher than the one preceding it. Every single rally high (resistance level) needs to be greater than the one prior to it.
If the corrective drop in an uptrend falls all the way down to the preceding low, it could be an early indication that the uptrend is halting or at least moving from an uptrend to a sideways trend. If the support level is violated, then a trend reversal from up to down is likely.
On every occasion that a former resistance peak is being tested, the uptrend is in a particularly critical phase. Failure to exceed a previous peak in an uptrend or the inability of prices to violate the previous support low in a downtrend is usually the first warning that the existing trend is changing.
Psychology of Support & Resistance Levels
At any one time in the market place there are three categories of participants – the longs, the shorts, and the uncommitted. The longs have already purchased shares, the shorts have already committed themselves to the sell side and the uncommitted are those who have sold previously and are waiting to re-enter, or who have remained undecided.
Assuming the market moves higher from a support area, where prices have been fluctuating for some time.
The longs that bought near the support area (A) will obviously be delighted, but regret not having bought more. If only the market would dip back near that support area again they would add to their long positions. The shorts now begin to realize that they are on the wrong side of the market and are hoping that the market dips back where they went short so that they can get out of the market where they got in and allow them to break even.
Those sitting on the side-lines that previously liquidated their positions too early are of course regretting their decision to sell prematurely and are hoping for another chance to reinstate their previous long positions. The undecided that had remained uncommitted, now finally realize that prices are going higher and resolve to enter the market on the long side on the next buying opportunity, which would obviously be at the support level.
All these groups are resolved to buy the next dip. They all have a “vested interest” in that support level under the market. Naturally if prices do fall near to that support, renewed buying by all these groups will result in pushing prices up. The more trading that takes place in that support area and the longer it takes the more significant and potent that support level becomes. The additional buying will create new levels of support with each downside reaction after the market advances as new buying takes place at these levels. Now let’s turn the tables and instead of prices moving higher, prices in fact move lower.
If prices start to drop below the previous support area, the reaction becomes just the opposite. All those who bought in that support area now realize that they made a mistake, and become sellers. This guides us into one of the more remarkable and lesser-recognized qualities of support and resistance – their role reversal. Each Time a support or resistance level is permeated by a significant amount, they switch roles. A resistance level converts to a support level and a support level switches into a resistance level.
The thing that produced the previous support to begin with was the high proportion of buy orders under the market. Now, however, all the previous buy orders under the market have become sell orders over the market. Support has become resistance. The more significant that previous support area was – the more potent it now becomes as a resistance area. All of the factors that created support by all three categories of participants – the longs, the shorts and the uncommitted – will now function to put a ceiling over prices on subsequent rallies to these levels.
Technical analysis is actually a study of human psychology and the reaction of traders to changing market conditions.
The study of support and resistance can tell an investor whether his ship is on course. As long as support levels hold firm, he can feel that his shares are doing well and he may buy more. If his shares breaks through a support level he has cause for concern, and may consider selling out.
Some traders use their studies of support and resistance to set up practical trading systems. They buy when shares have fallen to support levels, or when shares have risen and broken through resistance levels. They sell when shares hit resistance levels or fall through support levels.
If a share breaks out of a trading range of 50 – 55 and climbs, say, to 58, the previous resistance point of 55 becomes a support level. The short-term trader may not wish to hold on to the share if, on a downswing, it penetrates the 55 level. Longer-term traders may be content to hold the share as long as the lower level of the support zone (50) is not broken.
On daily charts the bottom of a support zone is considered more valid than the top. Very frequently a rising share will react back into a support zone and then resume its advance. A new support level may then form within the previous support zone and become the next valid support.
Weekly and monthly charts also reveal support and resistance levels, and are convenient for spotting long-established or “historic” levels for support and resistance. The potency of support and resistance has a tendency to fade with time, but many surprising examples exist which have proved to be significant.
As noted previously, an object in motion (a trend) will continue in motion until it meets an opposing force (support or resistance). The technical analyst continually works with both these tools, and he finds that they help each other. Trendlines help confirm support and resistance levels, while support and resistance levels help confirm and anticipate new trendlines.
Creating a Trading Strategy Using Trendlines
STEP ONE: Define the medium to longer-term trend
To define the medium term channel (i.e. the medium term support and resistance levels) select a medium to longer-term time scale (either select the daily (compressed like the previous chart of the Rand) or the weekly chart to the left).
I can now identify what my next move is, either buying or selling the Euro. Remembering that the medium term channel dominates this decision. In other words over the medium term, the probabilities of the Euro continuing to weaken against the US Dollar is higher than the probabilities of the Euro strengthening against the US Dollar.
STEP TWO: Define the short-term trend and stop placement
There are many different strategies one can come with by looking at the chart in the previous slide; the important thing is that you choose a strategy that best suits you the individual that is putting the money in. In other words assess your risk before entry, determine your exit strategy first and foremost and always make sure that for what you are risking your potential profit is at least three times bigger.
Too many people think about what could go right in the markets (how much money they could make) and ignore their stop losses or worse do not place any stops in the market. The first thought before entering the market should be about what could go wrong and how long am I going to stay wrong for.
Stop placement is essential for successful trading, placing your stops incorrectly could cause you to be whipsawed in and out of the market like a yoyo leaving you to desert your stop losses and taking much bigger losses than you wanted to.
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