Line Break Charts Explained Plus A Simple Trading Strategy

Posted in: Advanced Trading Strategies, Trading Article

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Line break charts were developed in Japan and popularized here by Steve Nisson in his book Beyond Candlesticks. The purpose of line break charts is to filter out market noise and give a clear indication of the current trend and trend reversals.

As you may know, sometimes determining the current trend can be difficult due to market price movement that consolidates, and a trend reversal can be just as difficult.

The 3 line break chart, as you will soon see, can make this process much easier.

This is a three line break chart of the daily Dow Industrials futures contract (YM).  You can see it could almost be mistaken for a candlestick chart or a renko chart but you will see that line break charts and candlestick charts are vastly different.

3 LINE BREAK CHART
Dow Industrials futures contract

The white and red bars are called lines. Notice that whenever we have consecutive white lines, each line has a higher close than the previous one; when we have consecutive red lines each line has a lower close than the previous line.

 

How Are 3 Line Break Charts Constructed?

Line break charts are defined by two values: the line break number and the underlying time interval. These values are used in the construction of the line break chart.

The chart above is a 3 line break chart of the daily YM and in this case the construction rules are as follows, assuming the last line on the chart was a white line:

  1.  If the close of the daily bar is higher than the high of the previous white line, draw a new white line with the open equal to the previous line’s high, and the close equal to the close of the current daily bar.
  2.  If the close of the daily bar is lower than the low of the last three lines, draw a new red line with the open equal to the previous line’s low and the close equal to the close of the current daily bar.
  3. If neither of the above two conditions are met, no new line is produced.

Why is it called a 3 line break chart?

As you can see from the construction rules, white lines are only drawn if the daily bar closes above the previous line, or if the daily bar closes below the lowest low of the last three lines.

The rules for red bars are the inverse of what they are for the white lines.

This charts shows the relationship between the 3 line break chart on top and the daily candlestick chart on the bottom. The numbers on the bars indicate how single bars or groups of bars on the daily chart relate to the white or red lines on the 3 line break chart.

Line Break Chart VS Candlestick Chart
Line Break Chart VS Candlestick Chart

It’s important to note that the construction of the line break charts is based on closing prices in the underlying time frame chart, in our example the daily chart. Daily highs and lows are not shown on the line break charts, just closing prices.

This needs to be borne in mind when back testing a line break chart trading strategy because we have no way of knowing how far price actually moved above or below the lines.

 

Trading Strategy And Line Break Charts

A trading system based on line break charts must must have all entries and exits based on the close or open of a line.  As mentioned earlier, the two key values of a line break chart are the line break number and the underlying time interval.

We can construct line break charts based on daily, weekly, 5 minute, hourly, any time frame, they can even be based on an underlying tick count, for example a 150 tick interval.  This allows us to adapt them for day trading or swing trading  systems.

The line break number itself can also be changed.  

Although the 3 line break is the most popular chart, it’s also possible to build 2 line break, 4 line break, etc. charts, the difference being that a reversing line needs to break the lowest low (or highest high) of the previous 2 or 4 lines respectively. This allows us to tailor the strength of the reversal needed to declare a change in trend direction, or change in line color.

 

Trading With The Line Break Chart

The simplest application of line break charts is to use the change in line color as a trade setup:

  • when the first white line forms, go long
  • when the next red line forms reverse to short
  • repeat for each change in direction.

Look back at the line break charts from earlier, we see that this can be quite an effective strategy in strongly trending markets, however during market consolidations it can lead to significant losses.

Alternating line colors are a clear sign of consolidation in the market and can help mitigate that risk somewhat by telling us when to stay out of the market.

 

Can Chart Patterns Be Used With 3 Line Break Charts?

Another approach that works well with line break charts is to use them for identifying simple candlestick chart patterns.

Charts Patterns and line break charts

This graphic shows how well the chart highlights a double top and double bottom formation that defined a short term trading channel.  A line closing below or above this channel gives us a clear setup for going long or short, and we can use the height of the channel in projecting the target for the move.

We could also use simple trend lines to indicate reversals or to help us trail a stop in an existing trend.

 

Line Break Trading Strategy With Indicators

It’s also possible to use line break charts in conjunction with standard technical analysis indicators in the creation of a system. Here we have a simple system based on a 3 line break chart with an exponential moving average and the CCI (commodity channel index) oscillator.

Line Break Chart Indicator Strategy

In this system long trades are entered when the CCI crosses above -100 and a white line closes above the exponential moving average; the trade is exited either when the CCI crosses below +100 or a red line is formed.

Rules for shorts are the inverse.

The green arrows show long or short entries and the red arrows show  the exits.

The entry or exit rules of course can be refined through the use of different or additional indicators and/or lower time frame charts.

 

Trend Direction Even Using Multiple Time Frame Charts

Finally, line break charts can serve as a directional filter for setups on different time frame charts. Only go long if the last line was white; go short if it was a red line.

 

In Summary

Line break charts can be a valuable addition to your trader’s tool chest. They can be used on their own or in combination with other charts. Just be careful when back testing these charts, remember that only closing prices are plotted, not highs and lows, so test results may look much better than real trading results would have been.

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