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A Simple But VERY Effective Guide to Trendlines
What are Trendlines?
A trend line is formed when a diagonal line can be drawn between two or more price pivot points. They are commonly used to judge entry and exit investment timing when trading securities. It can also be referred to as a dutch line as it was first used in Holland.
A trend line is a bounding line for the price movement of a security. A support trend line is formed when a securities price decreases and then rebounds at a pivot point that aligns with at least two previous support pivot points. Similarly a resistance trend line is formed when a securities price increases and then rebounds at a pivot point that aligns with at least two previous resistance pivot points. Stock often begin or end trending because of a stock catalyst such as a product launch or change in management. Below a Trend line on a daily price chart.
That is the definition of Trendlines according to Wikipedia.
rend lines are a simple and widely used technical analysis approach to judging entry and exit investment timing. To establish a trend line historical data, typically presented in the format of a chart such as the above price chart, is required. Historically, trend lines have been drawn by hand on paper charts, but it is now more common to use charting software that enables trend lines to be drawn on computer based charts. There are some charting software that will automatically generate trend lines, however most traders prefer to draw their own trend lines.
When establishing trend lines it is important to choose a chart based on a price interval that aligns with a trader's trading strategy. Short term traders tend to use charts based on small interval periods, such as 15, 5 and 1 minute, Tick or Volume Based Charts. Longer term traders use longer term charts. week and daily charts are the most widely used. Monthly interval periods also used, principally in order to establish secular trends.
The conservative way to draw trendlines: The Richard Wyckoff Method
Richard Wyckoff was a stock market authority, founder and onetime editor of the Magazine of Wall Street, and editor of Stock Market Technique. He was one the most influential, respected and successful Speculators of all time. His contribution to the field of Technical Analysis has been invaluable.
How to draw Wyckoff trendlines
Mr.Wyckoff used trendlines as a confirmation tool in his methodology . He looked for visual confirmation on market structure with Point and figures - Horizontal Chart - and for development or momentum on Bar Charts - Vertical Charts .
According to Wyckoff, When a stock is being bought (accumulation) this is the force of demand leading the price. This Action - demand creating higher stock prices - will remain dominant until The Reaction - the growing force of supply - begins to cancel the demand and prices retreat. This is a self repeating behavior that often results in a form of flat lining, as the equilibrium between supply and demand finally averages.
Trendlines help us understand the price movement, and when topping or bottoming occurs.
Wyckoff traders use support/resistance to watch for the tops and bottoms, conjunctively analyzing point and figure charts with trendlines.
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 additional demand and have bid the market higher, which is why Wyckoff called this line the demand line. In a downtrend, the downtrend line, or the supply line, shows where additional sellers have come into the market to arrest the bounces. If you are drawing standard trend lines, be certain of these points:
- They slope with the trend. Uptrend lines are upward sloping, and downtrend lines slope downward.
- Uptrend lines are underneath prices, marking areas of potential support. Downtrend lines are possible resistance areas, and must be drawn above
There aren't perfect ways to draw trendlines. The only thing one can do is try to use the same method. It creates habit and reduce subjectivity in what is already a mix of Art and Technical Skills.
Trendlines built the framework to help us understand that investors require perspective. It is imperative to differentiate between a short-term, a medium-term and a long-term trend.
Let's assume a scenario: A recent report is recommending the purchase of US Dollars.
If somebody tells you to buy the US dollar because it is likely to rise, make sure you understand whether the dollar is expected to rise over a few days or a few months.
That is the first step.
The next step is to determine if you should buy the dollar with the intention to hold it for several days, several weeks or several months.
The type of investment philosophy you follow will determine the best course of action.
For a technical inclined short term trader, the long-term horizon is entirely different from that of an institutional investor. For a the trader, l several days means long term while, for the investor, long term means months or years.
We can compare the charts and indicators to a clock (shown above).
The different time frames have different meanings to different participants.
I will try to illustrate the concept by comparing two extremes from the investment spectrum: The institutional Money Manager mindset and the short term trader mindset.
For an Institutional Investors managing large pools of funds, short-term trends (the seconds ) are best analyzed on daily bar charts . For a short term trader or scalper, it may be literally a matter of seconds.
To add more complexity and fun to the entire spectrum, for algorithmic driven High-Frequency Trading or H.F.T., it may take NANOSECONDS.
For Institutional Traders, medium-term trends (the minutes) are best seen on weekly bar charts and long-term trends (the hours) are best seen on monthly bar charts.
So investment horizon and timeframes are very relative terms. Some investors only want to know the weeks, some the days, others hours, whilst some only want to know the seconds!
Finally long-term trends (the hours) are best seen on monthly charts. For short term traders, it would be a 4 hour or daily chart.
In fact, for short term traders, there is an extra factor to be taken into consideration.
Holding positions for days, would represent Overnighting - sleeping with open position .
There are costs involved and extra risks.
Carrying positions is not usual practice for short term traders.
They rather go home Flat. No Exposure or whatsoever to worry about.
With that said, regardless the investor profile, trendlines can be very helpful in keeping them out of trouble.
Drawing lines to identify thresholds is a useful way to avoid getting in trouble.
The chart above shows three US dollar/Swiss franc trends.
1) The uptrend from 1995 to 1997 is long term timeframe. It is also called the PRIMARY trend (An Entire day or session for intraday traders )
It was broken by the 1998 decline. The long-term uptrend is not a straight line but is interrupted by corrections of a smaller degree.
2) These corrections are the medium-term timeframe or intermediate-term trends. (Hours for the intraday trader). They are also called SECONDARY trends. The medium-term correction is also not a straight line but is made up of smaller corrections.
3) These smaller trends are the short-term timeframe or trends. They are also called MINOR trends (For Intraday traders it would represent the fractions of hours or they could be switched to tick charts for further in-depth view).
A minor downtrend can be part of an intermediate- term uptrend, which itself can be part of a longer-term primary downtrend.
Sometimes it is difficult to differentiate between a short- and a medium-term or a long-term trend.
That is where technical tools such as Trendlines become helpful.
Technical analysis helps you to differentiate between the various trends in all financial markets and instruments.
I like to stress the word HELP, due to the fact that a many tend to build unrealistic expectations regarding technical analysis.
There is a countless amount of tools and methods available in technical analysis.
Before choosing one particular method, it is important to understand how they built, what are the strengths and the weaknesses.
Please do not take anything for granted.
Technical Tools are Tools!
Use them with the same care and attention that one should use prescription drugs.
They are helpful, but they have side-effects.
Markets are in constant movement. Every market operates under the principles of Price changes - bid and offers - an auction that leads to movements up or down. Speculators participate in markets with the objective to explore the excesses or lack of premium.
One of the most important principles to drive home wishing to become a successful speculator - trader or Investors - is to identify trends. It is one of the building blocks in Speculation, Trading or Investing.
Every professional or experienced trader stresses the importance of understanding the Major trends in Markets. In general, trading in the direction of the major trend can provide an edge towards successful outcomes. Poor choices have a better chance of being forgiven when made in the direction of a major trend. The importance of understanding trends cannot be overstated.
Humans seem to look for fancy and complicated solutions in life. They often disregard simplicity. Traders and investors are not different. Very often elegance is found in simplicity; trading isn't an exception. Very simple tools such as Trend Lines and Trend Channels can help to keep speculators in their assessment.
Simple solutions to help solve complex problems.