The most important use case for technical analysis is identifying uptrends and downtrends. Trend lines are tools that help traders successfully recognize trends. This article will help you to learn how to use this tool and will improve your chances of making a successful trade.
Drawing a Trendline
Trend lines are usually drawn on the charts by connecting the lows in an upward trend and the highs during a downward trend. There are different approaches to drawing trend lines, but the outlined approach offers a robust charting methodology.
A confirmed trend line normally requires at least three contact points with the price. We can always connect any two random points on the charts, but the trend line is an active trend line only if we have a third contact point. In addition, we must ensure our trend line does not excessively cut through the candlesticks.
Trend lines that go through candlestick bodies should be avoided, whereas a trend line passing through candlestick shadows may be OK under specific circumstances. It is not always possible to describe a trend with a trend line and if the chart does not offer one, we should not force it.
The trend in the figure below allows us to draw a trend line by connecting the lows. The trend line is confirmed on the third contact point and the fourth contact point provides another confirmation signal. Trend lines are used by traders to find trends and reversals alike.
Trend traders look for subsequent bounces to enter trades into the trend direction. The contact point 4 in the figure below shows such an example. Reversal traders wait for a confirmed breakout through the trend lines, anticipating a change in trend direction.
Trend Line Angle
As already mentioned, the slope of the trend waves indicates whether a trend is gaining or losing strength. The so-called bump-and-run formation comprises two parts: The trend progresses moderately in the initial phase, namely the lead-in phase. If the trend intensifies and the price moves away from the previous trend line, the bump phase is reached. It is well known that trends can lose their sustainability quickly if the price rises too fast.
This mechanism builds the foundation for the bump-and-run formation. If we see a significant increase in the angles of trend lines, we should be careful. The signal for a trend reversal and the run phase can be noticed when the price breaks the steeper trend line or when the price forms a new low as shown in the below figure.
The other trend line signal is given when trends with low or declining angles form on your charts. If the price moves slowly in one direction and the angle is extremely flat, this may indicate that market players do not fully support the trend and the ratio between buyers and sellers is more balanced. This prevents the price from rising or falling faster. Wedges are an example of this phenomenon as we have seen previously.
The left trend line in the below figure shows a scenario wherein the upward trend rises only slowly with a small angle. This indicates that although the buyers are in control, the buying interest does not significantly predominate. A slight shift can cause a trend reversal when the selling interest absorbs all the buying interest.
The break of the trend line confirms that the direction changes. The subsequent downward trend shows how flattening trend lines can point to the end of a trend as well. The sellers are gradually losing the upper hand and the ratio between the buyers and the sellers is becoming more and more balanced. This characteristic also builds the foundation of the wedge pattern
Combination of multiple Patterns and Trends
If two or more formations, patterns or signals such as wedges, candlestick patterns, and trend lines occur together, the signal force of different concepts is combined. This is called confluence in technical analysis. The signal strength of a trading situation normally increases when more confluence factors are combined.
When analyzing chart patterns, combining individual candlestick patterns with broader chart formations has proven to be helpful.
An example of this is a rejection or engulfing candlestick at the end of a double low – the spring pattern. As already mentioned, technical analysis works, among other things, because millions of market players use it and it leads to a self-fulfilling prophecy.
Not every trader will follow the Head-and-shoulders formation or use trend lines or candlestick patterns, but if several patterns and signals are clubbed together, more traders will become aware of them and then draw the same conclusions, increasing the probability of a successful trading opportunity.
Trend line breaks
A powerful trading signal is generated when an active trend line is broken. This often foreshadows a change in the trend direction and it confirms a shift in the market structure. The below figure shows various confirmed trend lines with more than three contact points in each case.
A break of a trend line always initiates a new trend. Interestingly, every break of a trend line is preceded by a change in the highs and lows first. When the price breaks a trend line during an upward trend, we can often notice how the trend has already formed lower highs. The break of the trend line is then the final signal, whereupon the trend reversal is initiated.
Subjectivity of trend lines
Traders can get into trouble quickly because it is not always obvious how a trend line can be drawn. If there are uncertainties in the correct application of the trend lines, it is advisable to combine them with horizontal breakouts. This makes trading more objective.
Thus, do not trade at the first signal when the price breaks the trend line, but only when the price subsequently forms a new low or high as well. These signals usually occur in quick succession, and hence the trader does not have to wait too long for his/her signal, but can nevertheless improve the quality of his/her trading and, at the same time, integrate another confluence factor into his/her trading.
Types of Trend Lines
There can be many variations of trend lines and it is important to understand the types of trend lines before you start using them
- Standard Trendline
Standard uptrend lines are drawn between higher lows in an uptrend; the standard downtrend line is a line drawn between lower highs in a downtrend.
The uptrend line shows where buyers have stepped in on the declines with more demand and have bid the market higher, which is why this line is called the demand line. In a downtrend, the downtrend line, or the supply line, shows where more sellers have come into the market to arrest the bounces.
- Parallel Trendline
The purpose of the parallel trend line is to create a trend channel that shows the range of fluctuations that the market has accepted as normal. In general, if you are long in an uptrend and prices rise to the upper parallel trend line, it probably makes sense to be slightly defensive and to take some profits.
- Supplement Trendline
In general, the strength of a trend line depends on the swing points used to define the line. However, there are some special cases where very short-term trend lines without good swings may give good trading signals. At some point in your development as trader, you may find that these small trend lines offer some interesting opportunities for precisely timing entries.
Trend Lines are an important tool for traders to analyze the market and find probable uptrends and downtrends. Trendlines can be helpful for traders to gauge areas of support and resistance and help to determine whether the trend will continue. Always remember that trend lines can also be used with different patterns and indicators to be sure whether the trend will continue to grow and increase the chances of profitability of the trader.