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How to Use Trendlines

Trendlines and Trend Channels are basic tools that all budding technical analysts can adopt. The new and increasing interest in charts among market participants has them looking for the holy grail and they often ask questions like “which moving average do you use’’. The right answer is that it does not matter.

The right moving average is the one that works best for you. Charts are a visual science and therefore it is more about method and psychology than about the secret number or should I say secret Ingredient.

So I will explain and discuss the use of this basic tool here that anyone can adopt. A trendline is the first and most basic tool for all technicians. Like the name says a trend line is used for the purpose of trend following. It can be used to support a bullish trend or a bearish trend.

In the following example we support a bullish trend. Here we draw a line that joins the two successive bottoms in a price chart. Note I am using bar charts that show the high and low of the day. So a trendline is joined together touching the two subsequent lows.

We then extend this line to the right as a support for prices to fall back on and go up. However if the trend is strong it is possible as shown here that prices make a higher bottom and move up again.

At that point we draw a new line of the two subsequent lows and extend it ahead as a new support line.

And repeat that process till we find a trendline that is repeatedly a support on every price dip. This becomes the most important line for this particular move till it is complete.

A trend reversal occurs when we finally break below the trendline by closing below it. I am using a daily chart here and so a daily close is relevant. The time frame you choose should be used for confirmation. So if you are using a weekly chart then a daily close below a line on weekly charts is not relevant.

You have to wait for the week to complete, i.e. Friday to be over to confirm that a weekly trend reversal occurred. Similarly on a daily chart an intraday move below the line can be a false signal or a ‘’Pinocchio Bar’’, named after the famous lying cartoon character whose nose grew on telling lies.

After the correction, you have to repeat the process. It can be now done at two levels. One is to plot a trendline of the two major lows as shown in yellow. And second a grey trendline for the new rally that has its own multiple support levels. Till broken again.

On the other hand the higher degree yellow trendline can also be redrawn to capture the rest of the trend till the trendline is broken much later as shown by the green and red arrows. In this way the use of Trendlines can be put to practice at various degrees of time and trend to capture what is going on.

Trend reversals can be used to exit from the trade when the trendlines break on closing basis. Drawing trendlines is also a dynamic process. You have to keep fitting the trend with the objective of riding it as far as possible and finding the best fit.

In a bearish trend the same technique has to be applied from the top down. After some practice it should be relatively easy and you will have a lot of trendlines on your charts

 

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