I can still remember the horror that “mathematical charts” filled me with in my school days: pie charts; x & y graphs; compasses; set-squares…
It’s really no wonder that so many adult traders – haunted my memories of maths teachers – view chart reading with some trepidation.
But the truth is, that with the aid of nothing more than your trusty ruler, you have the potential to make a great deal of money.
Today, I’d like to take a look at one of the most basic things we do with charts – something that traders do every day, but we probably each do it a little differently: drawing trend lines.
Reading patterns and plotting trend lines
Predicting prices through technical analysis makes the supposition that prices move in trends and patterns. And trend lines are an important part of our toolbox for identifying trends.
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 potential support or resistance.
How to draw a trend line
For an uptrend, draw the line along the lowest points in the trend without letting the line cross through prices. You need at least two touches of the trend line.
An uptrend line is simply a positive slope formed by connecting two or more low points. Uptrend lines act as support and indicate that demand is increasing even as the price rises, making it strongly bullish.
For a downtrend, it’s exactly the same, except you’re following the highest points in the trend.
A downtrend line is a negative slope, connecting two or more high points. These lines act as resistance and indicate that demand is reducing even as the price falls. This makes it very bearish.
Validating your trend line
You only require two points to draw in a trend line, but it isn’t validated until it touches a third time.
It can often be tricky to find three touch points, and it’s important to remember that there’s no need to force the issue – trend lines are an analytic tool, rather than something we should be “imposing” on our charts.
That said, there can be valid price trends that can’t be drawn with a neat 3-point trend line. Perhaps some market volatility has caused the price to spike above or below the line. In these cases, it is possible to ignore one or two points, where the spikes could be viewed as the price “overreacting”. This is called an internal trend line.
With internal trend lines, you can draw them through a “price cluster” (where prices are grouped within a tight range), which allows you to ignore the spike.
5 golden trend-line rules
1 • It takes two touches to draw a trend line, but three to confirm its validity.
2 • The more times a trend line is touched, the more significant it becomes.
3 • The steeper your trend line, the less reliable it is. A trend line resulting from a sharp price rise or fall will offer little meaningful support or resistance.
4 • Spacing: the touch points should be evenly spaced – not too close, and not too far.
5 • If the price breaks through a trend line, it does not always mean that the trend is over. There can be periods of acceleration within trend lines. When a breakout occurs, a supporting trend line becomes resistance; if it was resistance, it becomes support.
There is so much debate in trading books and over internet forums about the “correct” way to draw a trend line, it’s a wonder that any of us get them right.
The truth of the matter is that trend lines are subjective – give 10 people a chart to plot, and you’ll get 10 different lines.
Many people will always draw trend lines on closing prices, rather than highs and lows. This is a sound methodology, and I’d certainly follow it for long-term charts.
There are other traders who swear by Tom Demark’s dynamic trend lines – we can save those for another day!
Whatever trend lines you use, remember that they are a tool, and that the “aggressiveness” with which you draw them will have an impact on how they work for you.
By that, I mean that if you’re following close prices, you’re more likely to have your trend line hit, because it’s a more aggressive line. On the other hand, if you’re following highs or lows, there’s more space for spikes, so you’re less likely to experience false breakouts.
In the next seven days…
Following news this week that Ireland faces a double-dip recession, with national output dropping 1.2% in Q2 – we’ll be looking hard for some good news about the state of the UK and European economies.
Purchasing managers surveys are due out on Friday. In the UK, these numbers have been showing a slowdown in growth, last month’s being a 9-month low. The expectation is that this trend will continue.
By contrast, the US PMI last month showed an acceleration in growth – hopes are that this can be sustained in September’s numbers.