Trading the Trendline
Summary:
Technicians can easily become lost in the complexities of advanced price patterns and the tools used to interpret them. At times, the simple and clear signal is also the best. The trendline is one such tool. It tracks a straight line representing rising support in a short-term uptrend, or declining resistance in a short-term downtrend. As soon as the line is crossed, that is a signal that price may be about to reverse.
No single indicator is reliable for timing entry and exit. The trendline, like all technical reversal signals, needs confirmation from additional indicators: volume spikes, a narrowing of the trading range, or candlestick reversal patterns.
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Definitions:
A trendline is a straight line drawn beneath rising support level during an uptrend, or drawn above a falling resistance level in a downtrend. Support is the lowest price in the current trading range, and this is a dynamic, rising line when uptrends move rapidly. Resistance is the highest price in the current trading range, and it is a dynamic, declining line during a fast-moving, short-term downtrend.
A reversal is the turn in price, from uptrend to downtrend or vice versa. This turn is invariably signaled in some manner involving price and volume changes. A candlestick is a type of chart that shows the opening and closing prices, complete trading range, and the direction of price movement for every session.
Rules:
The most important rule in tracking price trends is that no single indicator is entirely reliable. It requires confirmation from one additional indicator before a trading decision should be made.
The trendline is easily developed and is highly visible. It signals a likely reversal; but some trends pause and then continue, so a trendline is not the last word, but only a starting point in the interpretation of the current trend.
Today’s technician recognizes that numerous indicators are valuable. In addition to relying on price-based patterns, technicians also rely on oscillators of many types, as well as on volume trends and spikes and on Eastern technical analysis. This consists mostly of the study and interpretation of candlesticks in one, two or three-session formations. These provide valuable confirmation of Western technical signs.
The trendline as a basic indicator
A trendline simply shows you how a trend is moving and also when it sends. It takes one of two forms. First is a straight line drawn below the level of rising support during an uptrend. The uptrend begins to end and then reverses as soon as the price level falls below support. Second is a straight line drawn above a falling resistance level during a downtrend. The downtrend appears to end when the price rises above the trendline.
For example, a three-month chart for IBM shows two trendlines, first an uptrend and then a downtrend.
Chart courtesy of StockCharts.com
The initial uptrend is easily recognized and defined by the trendline. Prices continue upward to the peak where a long white candlestick is followed by a downward price gap. The second trendline defines the downtrend that continues until the point that strong upward-moving sessions begin. This trend, like the downtrend, also begins with a price gap, this one moving upward.
The uptrend is especially useful in the kinds of trading patterns that move back and forth without setting any specific momentum in either direction. In the example, IBM’s price rallies four fours and then declines nine points and rebounds. These are less than enthusiastic price movements in either direction, and the trendline helps to define the duration of the short-term trend as well as likely points of reversal.
Confirming the indicated reversal
Every indicator requires some form of confirmation before it should be acted upon; and the trendline is no exception. In the case of IBM, the price gaps set the tone for the resulting reversal trend. This is a strong indicator that confirms what the trendline reveals separately. The short-term trading range ends just as reversal is confirmed with the gaps.
Other forms of confirmation may include:
- narrow range days (NRDs), sessions with very little space between opening and closing price. These days (called doji days in candlestick analysis) reveal a close struggle between buyers and sellers and often foreshadow reversal. The NRD is especially significant if the opening and close are narrow but the day’s full trading range was quite broad. This means that either buyers or sellers (or both) tried to move price in the desired direction but did not succeed.
- volume spikes, sessions in which the level of volume jumps far above average; volume spikes are especially meaningful when accompanied by NRDs. The volume spike reveals exceptional trading interest and activity on the session, often another sign of a coming price reversal within a session or two after the spike appears.
- candlestick indicators, of which there are dozens. These include the hangman man or hammer, engulfing patterns, piercing patterns, and meeting lines, to name only a few. Candlestick indicators are excellent forms of confirmation for Western indicators like the trendline.
Trendlines as a starting point
No technical indicators tell the whole story. The trendline is one another many different technical tools and it is not an answer to the question of when reversal will happen, but a great starting point.
Technical analysis is the process of spotting a trend or reversal and then seeking confirmation. Many indicators are subtle and difficult to spot, and others will appear only when a session is studied in different timeframes. The trendline has several advantages over the more complex patterns:
- It is easy to spot, and so is the point of reversal when the line is interrupted by a price change of direction.
- The trendline is most likely to hold whether you review daily, hourly, or even 5-minute charts. The trend tends to remain consistent and hold to the same points of reversal.
- This line lends itself to confirmation. As a trend reaches a valley or a peak, the tendency is for price patterns to also emerge. Many of these confirm reversal, while others contradict what the trendline seems to tell you. In these cases, the trendline might be readjusting as part of a continuation and a further extension of the line itself.
The important point to remember is that nothing provides a guarantee of reversal. The trendline is a great start because it is simple and easy to spot, and with confirmation it tends to accurately measure the duration and strength (or weakness) of the current trend. Used with other indicators, the trendline is always a great starting point in improving the timing of your trading decisions.
Michael C. Thomsett is author of over 70 books in the areas of real estate, stock market investment, and business management. His latest book is The Options Trading Body of Knowledge: The Definitive Source for Information About the Options Industry. Thomsett’s other best-selling books have sold over one million copies in total. These are Getting Started in Options, The Mathematics of Investing, and Getting Started in Real Estate Investing (John Wiley & Sons), Builders Guide to Accounting (Craftsman), How to Buy a House, Condo or Co-Op (Consumer Reports Books), and Little Black Book of Business Meetings (Amacom). Thomsett’s website is www.MichaelThomsett.com. He lives in Nashville, Tennessee and writes fulltime.
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