The Utility of Trendlines

What is the use of trend lines?

Bullish and bearish trends are hot topics among technical analysts and traders because they ensure that underlying market conditions work in favor of a trader’s position, rather than against them. Trendlines are easily recognizable lines that traders draw on charts to connect a series of prices together.

The resulting line is then used to give the trader a good idea of ​​the direction in which the value of an investment might move. In this article, you will find out how to use this tool. It won’t be long before you draw them on your own charts to increase your chances of a successful trade.

Understanding Trend Lines

Understanding the direction of an underlying trend is one of the most basic ways to increase the likelihood of a successful trade, as it ensures that general market forces are working in your favor.

Downtrend lines suggest that there is oversupply for the stock, a sign that market participants are more willing to sell an asset than buy it. As you can see below, when a descending trendline (black dotted line) is present, you should refrain from holding a long position; a gain on an upside is unlikely when the overall long-term trend is down.

Also note that there is a series of lower highs and lower lows, which is the mark of a confirmed downtrend. Conversely, an uptrend is a signal that the demand for the asset is greater than the supply and is used to suggest that the price is likely to continue higher.

Trend lines can vary widely, depending on the time frame used and the slope of the line. For example, some securities may show uptrend/downtrend aspects for months, days, or even minutes, while others may range and trade in a sideways trend.

Support and Resistance

Trendlines are a relatively simple tool that can be used to gauge the general direction of a given asset, but more importantly they can also be used by traders to help predict support and resistance areas. This means that trendlines are used to identify levels on a chart beyond which an asset’s price will struggle to move. This information can be very useful to traders looking for strategic entry levels or can even be used to manage risk effectively, by identifying areas to place stop-loss orders.

Technical traders pay particular attention to an asset when the price approaches a trendline, as these areas often play a major role in determining the short-term direction of the asset’s price. When the price approaches a major support/resistance level, two different scenarios can occur: the price will bounce off the trendline and continue in the direction of the previous trend, or it will move on the trendline , which can then be used. a sign that the current trend is reversing or weakening.

Draw your own trend lines

As mentioned earlier, trendlines are simply lines that connect a series of prices to give the trader a better idea of ​​where the price of a particular investment is headed. The problem comes in figuring out which prices are used to create the trendline. As you may know, the open, close, low, and high prices are easily obtained for most stocks, but which of these prices should be used when creating a trendline?

There is no single, distinct answer to this question. The technical signals generated by the various technical models/indicators are very subjective and trend lines are no exception. It is entirely the decision of the trader when it comes to choosing which points are used to create the line and no two traders will always agree to use the same points. Some traders will only connect close prices while others may choose to use a mix of close, open and high prices. Regardless of the prices connected, it is important to note that the more prices that touch the trendline, the stronger and more influential the line is believed to be.

In general, upward sloping trend lines are used to connect prices which act as support while the given asset is trending up. This means that ascending trend lines are mostly drawn below price and connect either a series of closes or period lows. Conversely, a descending trendline is typically used to connect a series of closing prices or period highs, which act as resistance while the given asset is trending lower. This is similar to what is shown in the table above.

Note that it is possible to use two trend lines on the same chart. However, this method, known as channeling, is beyond the scope of this article.

To illustrate the concept of drawing an ascending trend line, we chose to look at the trading action of AutoDesk Inc. (ADSK) between August 2004 and December 2005. As you can see below, the trend is drawn so as to connect the lows illustrated by the black arrows. Once a trendline is established, traders would expect to see the price of the asset continue to rise until the price closes below the newly formed support.

Over time, we can see in the chart below that price retested trendline support in August 2005. This is important because the closer price touches the trendline, the more influential the line is. . The price action shown by the far right arrow would be used by traders as confirmation that the trendline is valid. In this case, traders would be looking to enter a long position as close to the trendline as possible.

Once a technical trader has taken a position near the trendline, they will keep the position open until the price breaks below the trendline support. Most traders will constantly adjust their stop-loss orders by moving them up as the trendline continues to rise.

This method ensures that a trader can lock in as much of the gain as possible, without being removed from the position too soon. Maintaining a stop-loss order below an influential trendline is a strategic way to ensure that the asset has enough room to fluctuate, without getting caught out. In this case, using the ascending trendline as a guide to an expected upward move would result in a very profitable trade, as you can see below.

The essential

Trendlines are commonly used by traders looking to ensure that an asset’s underlying trend is working in favor of their position. Trendlines can be used effectively by traders to assess potential support/resistance areas, which can help determine the likelihood of the trend continuing.

This strategic advantage is available to any trader willing to take the time to learn how to draw a basic trendline and incorporate it into their trading strategy. Although many traders argue over what prices to use when creating the trendline, remember that all will agree that the strength of the trendline increases as prices test support/resistance.

Investopedia does not provide tax, investment or financial advice and services. The information is presented without taking into account the investment objectives, risk tolerance or financial situation of any specific investor and may not be suitable for all investors. Investing involves risk, including possible loss of principal.