How to Use Trendlines for Trading – Dispelling the Myths

Trendlines are a useful tool for visually highlighting a trend, and potentially being part of a trading strategy. There is a lot of myths and inaccurate information about trendlines though; learning how to use trendlines effectively–if you are going to use them–is crucial so you don’t fall into several common traps. Trendlines are a technical analysis tool used to define and project price trends in major markets such as stocks, forex and futures. Trendlines have the potential to alert us when a pullback (move against trend direction) is over and the trend is resuming, or when a trend is accelerating or reversing (for more on trends, see Impulse and Corrective Waves ). Price is the ultimate indicator though. Therefore, price action must always be considered when using trendlines.

Here’s how to use trendlines for trading.

Monitor Price Movement of Trends

Whether you use trendlines or indicators, price action is what ultimately determines how much money we make. Learning about price action and how trends move is never a bad idea. Once we understand the basic concepts of how prices move, then trendlines become a more effective tool in helping us analyze that price action.

Prices constantly move up and down, even within a trend. While most traders know this, they have a hard time applying that knowledge in real-time. Traders often wait too long before entering, buying near the top of a price wave,  panicking as the pullback begins, and selling at the exact time they should consider buying (during an uptrend). Trendlines, discussed later, can help in this regards.

Figure 1 shows a basic uptrend on a EURUSD daily chart. The uptrend begins by making a higher price high and then a higher price low (relative to the price waves that occurred prior). The price continues to make higher swing highs and higher swing lows. “Swings” refer to each major move up or down.

During an uptrend we see this progress of higher swing highs and higher swing lows. When the price creates a lower swing high or a lower swing low, the trend is potentially in jeopardy. Once the price makes both a lower swing high and lower swing low (they don’t need to be in that order) then a downtrend could be underway–or it at least presents the possibility that we could see more downside. Trends can last for a long time and many waves, or they may only last a few price waves.

During an downtrend we see lower swing highs and lower swing highs. When the price creates a higher swing high or a higher swing low, the downtrend may be reversing. Once the price makes both a higher swing high and higher swing low (they don’t need to be in that order) it becomes more likely that the price could move further to the upside overall.

Figure 1. Higher Highs and Higher Lows – An Uptrend

Pullbacks (in figure 1, a pullback is the price move between the swing high and swing low) within larger trends, such as a pullback on a weekly chart, can often appear as trends on shorter time frames such as the daily or hourly chart. Even on the daily chart above there are small waves within the larger labeled waves which haven’t been accounted for, yet in real-time could cause some confusion. Reading price action is subjective; the basic concepts stay the same but how each person views the trend may vary slightly based on what they see and the time frame they are trading on.

Understanding the basic concepts of price action is crucial, because it applies to every trend we trade. If trading with a trend we want to see this type of movement–higher highs and higher lows for an uptrend, and lower highs and lower lows for  downtrend. Once a trend is no longer exhibiting these characteristics caution is warranted. It doesn’t necessarily mean the trend is reversing, but is does indicate a deeper pullback is occurring, or a reversal is potentially underway.  Another key ingredient in reading price action is analyzing the velocity and magnitude  of price waves, then comparing the velocity and magnitude of each price wave to the price waves around it.

How Trendlines are Useful for Trading

Price charts produce “noise;” lots of price waves and random movements that can make it hard to pick out new trends as they form. Therefore, many traders prefer to simplify their charts. The uptrend in figure 1 is simplified by using a trendline, which highlights the trend and quickly shows the overall price direction.

This is very useful when looking at multiple time frames or when there are conflicting price action signals; by looking at the direction of the trendline traders can cut through the BS and see in which direction they should be trading.

Anytime there are two highs or two lows a trendline can be drawn. The trendline is drawn by connecting one high to the next, or one low to the next low. When starting out draw as many trendlines as possible, in all directions. This helps differentiate pullbacks and short-term trends from longer-term trends. We also often have an immediate bias when we look at a price chart, which may not always be correct. By forcing ourselves to draw all relevant trendlines, especially at the far right of the chart (most recent price action), we may realize our initial bias wasn’t correct at all. Being able to see trends and pullbacks of different sizes will aid you in your overall analysis and chart reading abilities. This skill can then be applied to trading strategies based on price action and trendlines (see How to Day Trade Forex in Two Hours or Less )

 How to Draw Trendlines on Your Chart

Trading software and charting platforms vary, but all of them should have a trendline or line tool. Select the tool. For an uptrend, connect the line from the low of one wave to the low of the next, and then extend it out to the right to provide a projection of where the next wave lows could possibly  occur.

For a downtrend, connect the high of one price wave to the high of the next price wave and then extend it out to the right. The lines provides a  projection for where future wave highs may occur.

If you are just starting out, freestockcharts.com is a free site with live real time price charts, and great technical analysis tools to try out. See How to Get the Most Out of FreeStockCharts  for information on how to navigate this free charting site.

 Figure 2. Trendlines on a EURUSD Daily Chart

How to Use Trendlines

for Trading – Adjustments Are Required

Trendlines are not only based on price, but also have a time element. This creates a great myth. Traders will often say that because a trendline is broken the trend is over. That is not true (similar errors are made when using indicators such as the MACD ). The price could break through a trendline just because it look longer for a wave to complete. This is very common when the price is moving sharply higher or lower. For example, if the price is making rapid higher highs and higher lows, the trendline will be angled steeply upwards. That type of momentum can’t last for ever, and eventually the trend will slow down. The price will break the trendline, but it doesn’t mean the trend is over, just that it has slowed down (as we should expect!). This is why we always consider price action in conjunction with trendlines.

Trendlines will often need to be redrawn. They are not a perfect trading tool that tells you exactly where a trend will reverse. You will draw a trendline connecting highs or lows, only to see that the next price wave doesn’t match up with the trendline–it doesn’t reach the trendline or overshoots it. You now must decide if that price wave is relevant, and if you want to redraw your trendline to accommodate.

For a long-term trend you may need to redraw the trendline multiple times. Alternatively you may keep each of the trendlines on your chart, showing the various stages the trend (near vertical, slow ascent, etc) has been through. This will remind you that conditions are always changing so don’t rely too heavily on the trendline… use price action analysis as well.

Figure 3 shows some trendlines applied to the Dow Jones Industrial Average ETF (DIA). The price action wasn’t very pretty during this time, but trendlines help us see when the price is trending, when it is pulling back and when it’s moving in a choppy fashion (no real trends present). Ideally, if using trendlines for trading purposes you want to be trading assets with strong trending tendencies. A chart/asset like this one is one you would avoid since trading signals are harder to pick out–the price is moving more laterally than trending. That said, for analytical purposes trendlines help us see what is happening so we can strategize for the future (sometimes the best strategy is to not trade when conditions don’t warrant it).

Figure 3. Multiple Trendlines/Redrawing Trendlines, with Commentary

(click to enlarge)

How I Use Trendlines in Trading

Instead of connecting exact highs to exact high, or exact lows to exact lows, I draw trendlines of “best fit.” Trendlines only show us an “area” of potential interest, not an exact price level of interest. While text books show examples of beautiful trendlines where the price seems to magically bounce off them at exact levels, that isn’t always the case in the real world (see figure 3).

A trendline of best fit connects as many highs together, or as many lows together, as possible. It is okay if the trendlines move through price bars (instead of running along exact highs and lows). The benefits are that the trendlines still show the overall movement of price, the trend direction and provides areas of interest (for potential trade signals, discussed next). The trendline also won’t need to be redrawn as often.

Figure 4. Trendline of “Best Fit”

Trendline of best fit (click to enlarge)

How to Use Trendlines for Trading – Trade Signals

There are multiple strategies which could combine trendlines and price action. Here is one such simplified strategy:

—When the trend is up, if a pullback stays above the prior swing low and moves into the vicinity of the rising trendline, enter long (buy) when the price moves back to the upside (trending direction).

—When the trend is down, if a pullback stays below the prior swing high and moves into the vicinity of the falling trendline, enter short when the price moves back to the downside (trending direction).

Trendlines often need to be redrawn, therefore the price touching or moving through a trendline is not a trade signal on its own. We must also look at overall price movement. If the price movement warrants a trade it must also produce a “trade trigger.” A trade trigger is a precise event which tells us right now is the time to enter. The Forex Engulfing Candle Strategy and the ABC Forex Trading Strategy Video  reveal entry techniques (trade triggers) and provide useful information for reading price action and using trendlines. These techniques are best used in conjunction with “trendlines of best fit.”

Trendlines help us keep focused and trading in the direction of the overall trend. The trendline provides an area where we should be on high alert for trading opportunities. This is especially true when using “lines of best fit” because multiple pullbacks have reversed near the trendline. See the prior mentioned articles (and some below) for exact methods of entry.

Fibonacci Retracements  are also used in conjunction with price analysis and trendlines to find areas the price is likely to pull back to.

In the case of a downtrend, stop loss orders are placed just above the high of the last pullback. In an uptrend, the stop loss is placed just below the low of the last pullback.

The above is a quick guide to general trendline use. For more specific entry methods and to determine exactly where to place a stop loss order, see Trending Trading: How to Spot Trading Opportunities  and the Day Trade Trending Strategy .

Figure 5. Trade Signals Using Price Action and Trendline Guidance

EURUSD 5 Minute Chart

Drawing Trend Channels

Connect highs to highs and lows to lows during a downtrend or uptrend and you will end up with a trend channel. As discussed above, a rising trendline (connecting the lows) during an uptrend can provide area of interest for seeking long positions. The line which connects the highs during an uptrend is also relevant. It lets you know where the price has had a tendency to pullback from, and therefore can aid you in picking a target price (profitable exit) for your trade. When drawing trend channels, trendlines of best fit are recommended.

(click to enlarge)

Using Fibonacci Extensions can also be quite valuable in determining exit points, as the extension levels are drawn based on recent price action.

How to Use Trendlines in Trading – Take Aways

Source: vantagepointtrading.com

Category: Forex

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