Trend Lines

Trend Lines

Trend lines help traders to monitor the flow of funds into and out of a financial instrument such as stocks, bonds, Forex or futures.

A downward trend line tells the trader that the flow of money is moving out of the market and the best odds of trading success will be placing trades on the sell/short side. Traders will want to concentrate on shorting rallies that have a short trade setup in the area of a trend line.

An upward trend line tells the trader that the flow of money is moving into the market and the best odds of trading success will be placing trades on the buy/long side. Traders will want to concentrate on buying pullbacks in the area of the upward trend line that has a buyable price pattern.

Traditional trend lines are thought to be immovable lines that once created will continue to work for a long time. It is dangerous to require the market to be too precise over the long run. The most recent information tends to be the most important and a trend line that was drawn from data that is 8 months old has far less significance than a trend line that was drawn from data that is a few days old.

Trend lines should be viewed as evolving indicators and updated with each new pivot high or pivot low. Trend lines can offer one of the earliest possible warnings of a change in the market that you are trading.

You may notice that we draw trend lines differently from more traditional trend lines. We do this because we believe this to be a more precise way to measure when a market may be changing its trend. They are evolving indicators that are changed with each new high or low. The power of a trend line comes when trying to predict turning points in a market.

Drawing the Uptrend Line

1. Start by marking off the low that preceded the highest high on the chart. This will be the last low before the highest high on the chart. This point is the anchor for the uptrend line and will only be moved when the stock moves to a new high (see figure 8.1).
2. Find and mark off the lowest low of the current upward move. This will be the lowest low of the current up move. This price is movable to the lows above if there is price interference such as long tails or one-off events that may not have a strong effect on the supply and demand situation at those lows.
3. Connect the two points to form the uptrend line.

Make sure that the uptrend line is extended into the future. It is preferred to have little to no price interference between the two connected points of the uptrend line.

Figure 8.1: The Uptrend Line.

Uptrend Line Break

The breaking of an uptrend line should not be viewed as an event that requires the trader to place a trade. Traders will need more information than just a break of an uptrend line to make a trading decision. It is essential to have as many other factors as possible like M patterns, major resistance with strong overhead supply, moving average resistance or any other form of bearish price pattern analysis in your favour before you place a short sell trade. It would also be wise to use some form of Fundamental Analysis or Sentiment Analysis.

Criteria of an uptrend line break (see figure 8.2):

• Initial Break: This occurs when the market breaks below its uptrend line. This is not the time to place a trade. It may just be a minor break before the uptrend continues. However, this may be the earliest sign that the behaviour of the uptrend is changing and you should be very alert to potential changes in the market.
• Retest and Failure: This occurs when the market moves back towards the prior peak and fails to move any higher and is now below the uptrend line. If a trader was to place a trade on a break of an uptrend line this would be the point. Look for other events and price patterns to confirm that the market has a strong chance of moving lower.

The sharper the market breaks the uptrend line the more likely it will be that the next retest of the prior high will fail to make a new high and set up a potential trading opportunity on the sell/short side.

Figure 8.2: Uptrend Line Break.

The uptrend line break can be viewed as a double top where many short sell strategies can be used.

The double top with a higher high on the second high of the double top can set up a very powerful reversal. This is based on the fact that traders have expectations of follow-through higher that have been negated causing them to panic sell to get out of their long positions. New short sellers enter new short positions after seeing the failed pattern and add to the downward pressure. Supply is overwhelming the demand.

Determining When an Uptrend Line Break is Valid

Figure 8.3 is NOT a valid break of the uptrend line on the initial move below the uptrend line. The reason for this is the prior pivot low in the uptrend was not overcome on the initial move lower. It may just be a reaction lower that could prove to be a short term move. We need to wait for more information before calling this a valid uptrend line break.

Traders will need to wait for the market to prove itself to be in a downtrend before we call this a broken uptrend line. This will become a downtrend when a candlestick closes below lower low 1 and after lower high 2 has been established. Lower low 2 does not have to become a pivot to confirm the new downtrend, breaking the low of lower low 1 will be enough confirmation (see figure 8.3).

The Stronger the pivots that forms at lower highs 1 and 2 the better. Having a stronger pivot will show an increase in supply (resistance, sellers) to possibly fuel the next move lower. Traders will react negatively to their failed expectations of the market moving to a new high which did not occur.

Figure 8.3: NOT a Valid Uptrend Line Break.

Figure 8.4 IS a valid break of the uptrend line on the initial move lower because the prior pivot low in the uptrend was violated.

This move lower will become a downtrend when lower high 2 becomes a pivot high or a close below lower low 2 has occurred.

Figure 8.4: A Valid Break of the Uptrend Line.

Drawing the Downtrend Line

1. Start by marking off the major high that preceded the lowest low on the chart (see figure 8.5). This will be the last high directly before the lowest low on the chart. This point will be the anchor for the downtrend line and will only be moved when the stock moves to a new low.
2. Find and mark off the highest high or peak of the current downward move. This will be the highest high before the last lower high. This price is movable to the highs above if there is price interference such as long tails that may not have a strong effect on the supply and demand situation at those highs.
3. Connect the two points to form the downtrend line.

Make sure that the downtrend line is extended into the future. It is preferred to have little to no price interference between the two points of the downtrend line.

Figure 8.5: The Downtrend Line.

Downtrend Line Break

The breaking of a downtrend line should not be viewed as an action to place a trade. You will need more information than just a break of a downtrend line to make a trading decision. It is essential to have as many other factors as possible like W patterns, major support with strong demand below, moving average support or any other form of bullish price pattern analysis in your favour before you place a trade. It would also be wise to use some form of Fundamental Analysis or Sentiment Analysis.

Criteria of a downtrend line break (figure 8.6):

1. Initial Break: This occurs when the market breaks above its downtrend line. This is not the time to place a trade. It may just be a minor break before the downtrend continues. However, this may be the earliest sign that something is changing in the downtrend and you should be very alert to potential changes in the market.
2. Retest and Failure: This occurs when the market moves back towards the prior low and fails to move any lower and is now above the downtrend line. If you were to place a trade on a break of a downtrend line this would be the point to do it. Look for other events and price patterns to confirm that the market has a strong chance of continuing higher and possibly reversing its trend.

The sharper the market breaks the downtrend line the more likely it will be that the next retest of the prior low will fail to make a new low and set up a potential trading opportunity on the buy side.

Figure 8.6: Downtrend Line Break.

The downtrend line break can be viewed as a double bottom and various trading strategies may be used here.

The double bottom with a lower low on the second bottom can set up a very powerful reversal. This is based on the fact that traders have expectations of follow through to the downside that has been negated when the market reversed higher. This causes them to panic and buy to get out of short positions. New buyers step in to open new positions after seeing the failed pattern and add to the buying pressure. Demand is overwhelming supply.

Determining When a Downtrend Line Break is Valid

Figure 8.7 is NOT a valid break of the downtrend line on the initial move higher through the downtrend line. The reason for this is the prior pivot high in the downtrend was not overcome on the initial move higher. It may simply be a reaction move higher that could prove to be a short term move, so we need to wait for more information before calling this a valid downtrend line break.

Traders will need to wait for the market to prove itself to be in an uptrend before we call this a broken downtrend line. This will become an uptrend when a candlestick closes above higher high 1 and after higher low 2 has been established (see figure 8.7). Higher high 2 does not have to become a pivot to confirm the new uptrend, breaking the high of higher high 1 will be enough confirmation.

The Stronger the pivot point the better. Having a stronger pivot will show an increase in demand (support, buyers) to possibly fuel the next move higher. This lies in trader’s reactions to their failed expectations of the market moving to a new low which did not occur.

Figure 8.7: NOT a Valid Break of the Downtrend Line.

Figure 8.8 IS a valid break of the downtrend line on the initial move higher because the prior pivot high in the downtrend has been violated.

This move lower will become an uptrend when higher low 2 becomes a pivot low or a close above higher high 2 has occurred.

Figure 8.8: This IS a Valid Break of the Downtrend Line.