Market prices, like a lot of things in nature move in a particular pattern. Just as the ocean which witnesses high tides and low tides every day, markets too move in trend.
When prices move in a upward direction it is call an uptrend and when they move in a downward direction it is called downtrend. However, just like waves prices too take a breather. They do not go up in a straight line but come down in between to catch their breath before resuming their journey higher. Same is the case in down trend.
The chart below shows the price movement in an uptrend and downtrend.
Technically an uptrend is defined as a series of successive high along with higher lows. Note in the chart how prices make successive highs and correct or retrace to some extent but their lows are always above the previous low.
Similarly in a downtrend prices make successive lows along with lower highs. The chart shows that in the downtrend prices have made new successive lows at the same time the correction or retracement is also a lower high than the previous high.
A beginner to technical analysis or trading generally finds it difficult to identify trend. A common rule of thumb is that a stock is in an uptrend then the chart would rise from the left hand lower corner of the computer screen to the right hand upper corner of the screen. In the case of downtrends prices would be falling from the top left hand corner of the screen to the bottom right hand corner.
There is another way to determine the price trend, which can be done by drawing trend lines, which basically follow the trends.
Also Read : Decoding a Technical Chart
One of the first things that a child is taught when he starts to learn how to hold a pencil is to draw straight lines. And if he turns out to be a trader as he grows up he would understand the importance of drawing lines.
Unarguably one of the most potent in the hands of a trader, these lines which when used on a chart is called trend lines or support and resistance lines.
A trend line is used by traders and technical analysts for trend identification and confirmation. It is basically a straight line that connects two or more price points which can be extended into the future to act as a line of support or resistance.
Rising trend lines
The chart below shows a rising trend line which is being repeatedly tested by price touching it and bouncing back. When a trend line is drawn below the price movement by joining the swing lows, it is a rising trend line and the market is in an uptrend.
Falling trend lines
What is obvious from the chart above is that since the trend line is rising the stock is in an uptrend. If the trend line would be sloping downwards the stock would have been in a downtrend as seen in the chart below. In a falling trend line prices are below the trend line and the trend is down.
Sideways trend lines
In a sideways trending market the trend lines are flat and are normally called as support or resistance lines, as in since in the chart below. In a flat market, when trend lines are drawn below the prices by joining swing lows it is called as a support line or simply support. Similarly, when a line is drawn joining the swing tops it is called as a resistance line or simply resistance.
Trend lines are great visual tools to determine the trend of the market and are considered as very important points which offer one of the best risk-reward trades.
Trend lines as speed indicator
Apart from the fact that trend lines help identify the trend, they also help in showcasing the speed of the trend. The chart below shows two trend lines. The one with a smaller angle start at the left corner of the price chart is the slower trend line. The one starting in the middle of the chart is the faster trend line. As can be seen from the chart, even when the faster trend line was broken, price came and settled at the slower trend line. It again tried to move higher but the faster trend line acted as a resistance.
Though the definition seems to be simple drawing a trend line can get complex. It needs to be clear that while drawing a rising trend line, it is not necessary that all the lows shout be touching. It is basically a line which fits best on the chart and prices test it and bounce back. In search of perfection traders generally end up drawing wrong trend lines and miss out on important trades.
A slower sloping trend lines represents a passive sentiment and a steeper sloping trend line indicates a more aggressive trend.
Length of the trend line
Another important message that a trend line gives is through its length and the number of time it is tested. If a trend line has been tested a number of times and prices have bounced back from it then its validity is very important. A break of this trend line will not only indicate a change in trend but also signals a big move on the other side. Similarly the number of times the line is tested is also important.
The chart below has been compressed to show the importance of the length of a trend line. The falling trend line was broken after nearly a year. Prices broke through the trend line and reached the top of the falling trend with a span of less than two months. For around a year the trend line acted as a resistance from price to going higher, but when it did, it did it with a vengeance.
Drawing a trend line
Now that we know what a trend line looks like and its significance, let’s see how trend lines are drawn. Drawing a trend line is not a science; it’s an art. A common mistake that many technical analysts and traders make is try to make an ideal trend line by joining the lowest points of swing lows for a rising trend line a highest points of swings high for a falling trend line.
What is important is to draw a line that is the best fit. Where prices have repeatedly tested and moved back. Drawing a trend line is usually a work-in-progress. It needs to be adjusted occasionally to take care of the slight penetrations.
Apart from a visual method of drawing a trend line, some technical analyst used a refined method. Here in a rising trend, the lowest point of the swing is taken as one point and the swing low just preceding the new high is taken as the other point. Joining these two points and extending it gives us a passive rising trend line. However, within this up trend, there can be many rising and falling trend lines, as can be seen in the chart below.
Breaking of a trend line
Just as important a trend line is, breaking the trend line has equal importance if not more. Since trend lines are observed by many traders, the general view is that the trend line should hold. Traders take long position in a rising trend line when prices approach it as the risk or stop loss is very close. This offers them a very good reward for a small amount of risk if the trade is in favour.
However, if the line breaks stop losses of the traders itself adds to the move on the down side. Further, as a break of the trend line is considered as a change of trend many other traders join in to exploit the opportunity on the other side.
However, prices penetrating the trend line are not considered as a break. Prices tend to test the trend line repeated during its life, but a close below a rising trend line and a close above a falling trend line show raise the red flag.
Many purists expect three successive closing on the other side of the trend as a change of trend. Some others consider the normal definition of a change of trend where the previous swing low is in rising trend and swing high in a falling trend is penetrated after the trend line is pierced as the change of trend.
However, the beauty of trend line is that after they are broken, prices generally come close to it to test the line again. It would be safer to trade at these ‘test’ point of price at the trend lines as can be seen in the chart below.
For a traders and technical analysts stock trend lines are one of the simplest and strongest tools in his arsenal. Since the time prices have been plotted on charts they have an uncanny habit of testing the trend lines. They will continue to do so in future. Having a strategy around tests and failure of trend lines can bode well for a trader in the long run.