How To Draw and Use Trendlines to Make Investing Decisions

Trendlines are the backbone of technical analysis. They are an incredibly useful tool and yet they are also very simple. Knowing how to use them, however, can be slightly more complex. There is often a lot more to trendlines than what meets the eye, and the experienced technician is able to draw out and extrapolate the relevant information from the price action. Multiple trendlines can form large and significant market patterns. Therefore it is no surprise that trendlines are the building blocks of price interpretation. In this update I am going to explain the various ways you can use trendlines to make investing decisions, as well as their classical definitions and combinations, and how and when to draw them.

 

Drawing Trendlines

 

There may be more than one way to draw trendlines on a chart. I am going to explain the way that Robert Edwards and John Magee first described them in their pioneer work titled Technical Analysis of Stock Trends. This is one of the three books that the level 1 CMT exam covers as dictated by the MTA, and a very familiar source to Market Technicians. I also highly recommend this book to anyone who wants an in-depth yet elegantly simple education on technical analysis and investment principles.

 

Trendlines can be drawn on the upper bounds of price action or on the lower bounds of price action. An upper trendline is also known as a blue line and a lower trendline is also known as a red line. Trendlines require two established top reversal points for upper trendlines or two established bottom reversal points for lower trendlines, in order that these points may be connected by the line. Minor highs and lows are good candidates for potential reversal points. On a top these points are called reaction points and at a bottom they are called basing points.

 

These reversal points must have low (bottom) or high (top) that is flanked by two higher closes (bottom) or two lower closes (top). The established reversal points can more strictly be defined once the range of the current bar or candle has moved completely above (low) or below (top) the most recent extreme point in the move. In the figure the shaded area represents the level where the current candle must remain entirely outside of in its range. Once this has been accomplished a basing or reaction point has been established.

 

Trendline parallels can be drawn to create trend channels as price moves back and forth upon a fixed plane. Trendline parallels may be drawn with only one established top or bottom if the point is opposite either a red or blue line. These parallels are useful for estimating the extent of possible moves as well as making decisions to buy or sell stock and securities or preparing one to make such decisions. The parallel line should be drawn parallel to the original trendline, and in the same color but with a broken or dotted line. These parallels can be drawn when reversal points have been established as defined above.

 

There are certain cases where reversal points are obscure due to rounded or irregular reversal formations. In these cases a Market Technician must have experience with numerous forms of market action in order to confidently identify and establish these points.

 

Preparatory Trend Signals

 

Now that I have explained how to draw and define trendlines I will describe the various methods one can use to form investing decisions after the initial lines have been established. Please note that unless one is acting upon fundamental information, all buying signals shall be initiated in uptrends and all selling signals initiation in downtrends. Technicians are not justified in taking positions against the trend because these reactionary moves will always be smaller if you are fighting the trend. For example an uptrend, by definition, will be making higher highs and lower lows, and one is not justified in selling short on reactions. The appropriate decision is to wait until reactions have run their course and buy or pyramid at the bottom reversal points.

 

Preparatory Buying Signals

 

These are the buying signals that alert a technician to potential moves in the price of a security just before they may or may not develop to the upside:

 

  • Contact with the ascending Blue Line if the Red Line is also ascending in parallel
  • Contact with the horizontal Blue Line if the Red Line is also horizontal or ascending
  • Penetration of a descending Blue Line on volume if Red Line is ascending

 

These are the buy signals that occur after a preparatory buy signal has been identified.

 

  • If the Blue Line has been ascending, draw the Blue Parallel and buy at or near this line
  • If the Blue Line has been horizontal or descending in the case of rectangles, triangles, and other various reversal patterns, buy on a reaction of 40 to 60% of the move from the last previous minor bottom to the extreme top of the most recent move

 

See Diagram 1 below for a full explanation of the various trendline patterns, including trendline breaks that do not satisfy legitimate buy signals.

A. Penetration of an ascending Blue Line

B. Penetration of a horizontal Blue Line

C. Penetration of a descending Blue Line without other technical indications is not conclusive evidence of a change in trend, and does not justify long committments

D. Contact with the Blue Line of an ascending parallel trend pattern

E. Contact with the Blue Line of an ascending divergent pattern

F. The contact with a Blue Line here does not suggest a buy on the next, since trend appears to be converging in a rising wedge – a bearish formation

G. Contact with the Blue Line of a rectangle at its fifth point of reversal

H. Contact with the Blue Line of an ascending triangle

I. Penetration on volume of a descending Blue Line when the Red Line is ascending in a symmetrical triangle

 

 

Preparatory Shorting Signals

 

These are the short selling signals that alert a technician to potential moves in the price of a security just before they may or may not develop to the downside:

 

  • Penetration of a Red Line to a new low closing
  • Contact with the descending Red Line if the Blue Line is also descending and the trends are not converging in a wedge formation
  • Penetration of the ascending Red Line with or without volume if the Blue Line is descending in the case of a symmetrical triangle

 

These are the sell signals that occur after a preparatory buy signal has been identified.

 

  • If the Red Line has been descending, draw the Red Parallel and sell at or near this line
  • If the Red Line has been horizontal or ascending, in the case of rectangles triangles, and various reversal patterns, sell on a rally of 40 to 60% of the distance from the last previous minor top to the extreme bottom of the most recent move

 

See Diagram 2 below for a full explanation of the various trendline patterns, including trendline breaks that do not satisfy legitimate short selling signals.

 

J. Penetration of a descending Red Line

K. Penetration of a horizontal Red Line

L. The penetration of an ascending Red Line without other technical indications is not conclusive evidence of a change in trend, and does not justify short committments

M. Contact with the Red Line of a descending parallel trend

N. Contact with the Red Line of a descending divergent trend pattern

O. Contact with the Red Line in this case does not suggest a short sale on the next rally, since the trend appears to be converging in a falling wedge – a bullish formation.

P. Contact with the Red Line of a rectangle at its fifth point of reversal

Q. Contact with the Red Line of a descending triangle

R Penetration of the ascending Red Line with or without volume when the Blue Line is descending to form a symmetrical triangle.

 

Some Additional Notes

 

If a stock that has been trending and stalls in a congestion zone of two to three weeks or longer without providing any signal one way or another by price or volume action, it is wise to consider this consolidation as a key area and therefore its own minor top or bottom. This allows one to adjust their stops accordingly in the event that the trend peters out from this key level or pyramid to their position in the event that the trend continues higher. Again this takes some experience on the part of the Market Technician to determine just when and where to place the stop. Remember stops are never moved down in an uptrend (or up in a downtrend in the case of short selling) but should be moved up with each minor bottom according to the investor’s tolerance for risk and their investment strategy. For example, a long-term fundamental investor may choose to wait out any intermediate reactions as they develop while a short-to-intermediate investor might choose to close out their position on any break in a major trend.

 

Keep in mind that climatic volume often occurs at the end of an uptrend, and while not a selling signal itself, it is wise not to add further commitments to your open position after this warning signal. These climatic moves often signal the beginning or near beginning of an intermediate trend, and the astute investor would be wise to closely monitor their position in the event this type of volume has occurred. These moves are dangerous as weak investors flock to the rapid price advance and great volume, setting the stage for final “blow-off” moves where the reversal volume and price action become exacerbated.

 

Trading Intermediate Trends

 

Intermediate trends may be traded after an extended move or serious of moves in the primary direction. Typically a technician would look for any warning signs that the trend is exhausted and confirmed on breaks from either the ascending Red Line (in an uptrend) or the descending Blue Line (in a downtrend). Keep in mind that price targets in the opposite direction should be kept in line with intermediate reactionary moves and not more until proven otherwise.

 

Summary

 

  • Trendlines are the building blocks of technical analysis
  • Two or more trends can meet to form patterns
  • Trends can alternate to form larger patterns
  • You need at least two established reversal points to form a trendline
  • The top trendline is blue – “upper trendline”
  • The bottom trendline is red – “lower trendline”
  • The Blue Parallel is the bottom line of a Blue Line and is dotted
  • The Red Parallel is the top line of a Red Line and is dotted
  • Initiating positions must be justified by going long on uptrends and short on downtrends, since reactions will be smaller than rallies in uptrends and vice versa for downtrends
  • Be wary of climatic volume near upper trendlines for a top and lower trendlines for a bottom
  • Intermediate reactionary trends may be traded provided climatic volume has occurred and price targets are in line with intermediate moves

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