TRADING BASICS: TRENDLINES

26. Nov. 2023

Trend lines are the simplest and most basic concept of technical analysis. It is also, paradoxically, one of the most effective tools. Since almost all price patterns require the use of trend lines, the latter are the basic element of both pattern definition and its use. Now we will discuss what trend lines are, how to work with them and how to determine whether they are working.

A trendline is a straight line that connects descending lows in a rising market or highs in a falling market. Lines that connect lows are called rising trend lines, and those that connect highs are called falling trend lines. To make a falling trend line, we connect the first high to the subsequent highs. When the price breaks the trend line, it is a hint that the trend may change. Similarly, for a rising line.

How to draw a trend line? ✔️
For a trend line to be real, it must connect the previous highs or lows. Otherwise, there is no sense in such a line at all. This is called the major trend line. It is where the first low of a bearish trend connects to the first intermediate low. In the example below, the trend line is not particularly steep (it is at a low angle, and angles are important in a trend). Unfortunately, price then accelerates sharply after the next low.


In a situation like this, it's best to simply redraw the trendline as price moves further away. This is called a new line in the picture and it reflects the changed trend much better. This line will be a secondary trend line. Well, the downtrend lines are drawn in the same way, but in reverse.

Since the trend can go sideways, it is quite possible to guess that trend lines can be drawn horizontally. This is often the case when we find price patterns like the "neck" in the Head and Shoulders pattern, or the upper and lower borders of triangles. In such patterns, if the trend line is crossed, it is an indication that the trend is changing. The same is true for rising and falling trends.

It is also important to realize that drawing a trend line is a matter of using common sense, not a set of very strict rules.

A trendline breakout could indicate a reversal or consolidation

The completion of a price pattern can indicate:

1. reversal of the previous trend, aka reversal pattern;
2. continuation of the previous trend, aka consolidation or continuation pattern.

Similarly, a trend line breakout indicates either a reversal of the trend or a continuation of the trend.



An example demonstrates this concept for a downtrend.
In this case, the trend line connecting one high after another is broken in a downtrend. The fourth high will be the highest point of the bearish trend, so an upward breakout of the trend line in this case indicates the beginning of a bullish trend.



In the picture above we see again a rising trend and a trend line breakout, but this signal has a completely different outcome. The reason is that the break of the trend line caused the trend to continue, but at a much slower pace. The third scenario is when the price goes into consolidation (aka sideways) instead of reversing, which is shown in picture. Accordingly, when a trendline is broken, it is a strong indication of a trend reversal. A changed trend can eventually reverse or go sideways after rising or falling.


Unfortunately, in most cases we can't tell accurately what will follow a trendline breakdown. However, there can be some pretty good clues, such as the angle of the trendline. Since trends that run at an acute angle are less stable, their breakout more often leads to sideways rather than reversals. Useful hints can be hidden in the general state of the technical structure of the market. In addition, a trend line breakout often occurs at the successful completion of a reversal price pattern or shortly before.

Extended trend lines ✔️
Many beginners, when they see that a trend line is broken, automatically conclude that the trend is about to change and immediately forget about the line. After all, an extended trend line can be as important as the fact of its breakdown. For example, if a rising trend line is broken, the price very often returns to the same line, but later. This is called a throwback.


Significance of trend lines ✔️
So, we have it all figured out - a trend line breakout leads to either a trend reversal or a trend slowdown. Of course, it is not always possible to say what exactly happens there, but we need to understand how effective a trend line breakout is in general, which we are going to do now.

In general, the significance of this event depends on three factors:

The length of the line;
The number of touches;
The angle of inclination or rise.

1. Trend line length ✔️
A trend line is used to measure a trend. The longer the line, the longer the trend and the more such a line will become important to us. If descending lows come one after another for 3-4 weeks, such a trendline is less relevant. If the trend line lasts 1-3 years, its breakout is extremely important to us. The breakout of an old trend line is very important, it is a powerful signal. The breakout of a fresh (relatively) trend line is a less important signal.

2. Number of touches or approaches to the trend line ✔️
The more touches or interactions with the trend line, the more important it is, there is a direct correlation. Why is this so? Because the trend line represents a dynamic zone of support or resistance. Each successful touch of the line strengthens it, reinforces its importance as a support or resistance zone. Thus, the trend line's role as a guide for the trend as such is also strengthened. Approaching the trend line is no less important than touching it, because this is how the zone is actualized. If the trend line has become strong due to the touches, its continuation will be no less strong, but from the other side. After all, in an extended trend line, support often becomes resistance and vice versa.

3. Angle of slope ✔️
A very steep trend is usually unstable and easily broken, even by a short sideways movement. All trends break sooner or later, this is a fact. However, steep trends break much faster. The breakout of a steep trend is less significant than the breakout of a smooth and gradual trend. It sounds paradoxical, but the point is this - the break of a steep trend usually causes a short correction, sideways price movement, after which the trend resumes, but much less strong and smoother. Accordingly, the breakout of a steep trend line is a confirming pattern, not a reversal pattern at all.

To summarize
Trend lines are an easy tool to understand, but they must be used correctly and thoughtfully. A trend line breakout indicates a temporary interruption of the trend or a reversal of the main trend. The significance of a trend line consists of its length, the number of touches/approaches to it and the slope angle. A good trend line always reflects the underlying trend and forms significant support and resistance areas. Extended trend lines change former support/resistance in places, which should be paid special attention to.

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