- April 22, 2016
- Posted by: CoachShane
- Categories: Advanced Trading Strategies, Trading Article
Like most forms of technical analysis, trend lines are often abused, misused, and for the most part are not drawn with any sort of consistency.
They can be very useful but virtually like anything else in your trading plan, you have to find consistency in how you use them.
Let’s look at what trend lines mean and then list out a few ways you can draw them.
We will then follow-up on a 1-2-3 reversal made popular by Vic Sperandeo
Trend Lines Help In Swing Analysis
Markets go up, down, sideways and when a market is trending, looking at the impulse and corrective swings can tell you the strength or weakness of a trend.
When a market is trending up, we expect to have impulse moves larger in length than the corrective declines against the trend. This shows that the demand is still high for the particular market.
When those who were interested in buying starts to thin out, we start to see the impulse moves getting shorter and losing steam. We may start to see the corrections begin to increase in size.
There will come a time when the buyers are done and supply enters the market. When this occurs, we will start to see the correction larger in scope than the impulse moves.
This graphic shows the typical uptrend in action. Large thrusting impulse moves with smaller corrections.
What we see happen at #1 is that the demand for this instrument is beginning to stall although the corrections are not showing an increase in supply at this time.
When the last push upwards occurs, supply enters the market and you can see that the rhythm of the uptrend has now been broken at #2. Our corrective decline is much larger than the impulse move and we also took out previous lows.
Being in tune with the swings in this example can give you a “heads up” to either lighten a position, take a quick scalping trade or to refrain from entering any new long positions. Once momentum to the downside occurs, this may be the time to exit a position.
The next image shows a trend line trading technique of connecting the lows which can help you determine when a change of state in the market has occurred.
This does not mean a trend change but is a visual clue that at this point in time, what was a steady uptrend has met some strong supply.
The next possible actions that could occur include a retest of the highs, a consolidation, a complex correction, which simply means, there really is not a trade setup at this moment. We’ve simply had buyers not supporting the market at that current price and a rapid trend trade may not be a smart trading plan.
You will see two smaller lines and as the market kept making new highs, we were presented with new lows to attach our trend line to. This is called trend line fanning and is used to “track” the rate of the trend during the up move. The line with the arrow would be the latest line drawn in keeping with this method of drawing a trend line.
Climax Move Trend Line Fan
What we often see in a market is a steady trend move and then a burst of activity where price will quickly advance in the direction of the current trend.
These can be very tricky as some traders may look at it as intense interest in the market and look to position in the direction.
Other traders will look at the same move as being out of the ordinary advance of the trend and stand aside thinking we have a climax or exhaustion move in the instrument.
In this graphic, our #1 trend line can neatly meet the lows which shows the market is moving in a more or less consistent volatility.
The #2 line shows the market has strongly advanced as our impulse moves have become much more intense giving us swing lows outside the volatility of the previous trend.
As more people pile into the move, it sets the stage for a sudden and violent drop in price as the corrective decline wipes out both trend lines and a previous swing level.
There are a few strategies to take a trade when these events occur but are outside the scope of this piece.
If you are so inclined, you could research taking a pullback trade short after sudden moves like this as those looking to short step in and those traders that got trapped in their long positions get out of their position when they see that a pullback to re-engage the trend, has failed.
The bottom line with these sudden and often violent surges in price is that you could be looking at a top (at least in the short term) in the current move and those long are about to weather a sudden move against their position.
These are not the times to establish a new position in the uptrend until you see what price does after the move.
Don’t let the fear of missing out on a trade lead you to jump in just as the market begins the turn.
Learn To Draw A Trend Line Consistently
There is no hard and fast rule when it comes to drawing a trend line correctly but you should have a consistent method of choosing the lows or highs you will use in their construction.
Keeping in mind what the trend line represents as discussed earlier and that many traders will use them as support and resistance zones, will help you determine what suits you best.
If you haven’t heard of Victor Sperandeo, you can read more about him and his thoughts on trading in his book “Lessons From A Wall Street Master”.
In drawing a trend line, Vic would start where the move began as an anchor point. Assuming an uptrend, when price made a low and then hit a higher high than the previous, the line would be adjusted to that swing low without cutting through any candles. If that was not possible, a new trend line would be drawn using a new anchor point to the next higher low.
Taking a look at this chart, you can see there were several different lines that were eventually drawn.
For simplicity sake, I have omitted any supply lines to avoid further clutter on this chart.
- This is a cheap line due to the lack of pullbacks at this point in time and I used a congestion area for the second touch. This is a weekly chart and there are pullbacks on the daily chart. If trading a chart like this, it can be a tough go as the market appears to just grind higher.
- Actually have a swing level that precedes a swing high so a new line must be drawn. Price breaks the line and once price retests the high and then breaks the previous swing level, you can consider a change of trend.
- Price breaks a swing high and the new swing low is used with original anchor. You can see the next swing level tests the line and then moves up giving us…..
- A new anchor point as the market begins to accelerate to the upside.
- & 6 are up for consideration in regards to the swing level and I lean to number 5 as number 6 appears to be a failure test of the low of that range marked in red. Although price did not breach the high which is a requirement for the changing of the lows for the trend line, close, is close enough.
Price breaches the #5 line several times, forms a triple top and then collapses. Price remains in a downtrend to this day and this area marked a turn of the trend.
The rules are quite simple:
- Use the initial anchor where price changed trend
- Each time price makes a new high, use the previous low to draw to from the anchor
- If the trend line starts to cut through price, there is a change in the rhythm of the market and possibly a change in trend.
- Use a new anchor point to fan the trend line
- Continue to meet new higher lows until a reversal pattern emerges
Another method you can use with consistency is the TD Trend line by Tom DeMark. You can research more about him and how he approaches the markets at this link.
In short, we are connecting pivot levels that are at least a three candle pattern where, in the case of an uptrend, the middle candles is the lowest of the three. You can obviously cut down on the amount of lines by using a five candle pattern. I’ve used two different colored lines to distinguish between them when the are in the same area.
I’ve highlighted a few areas of interest that really stood out for me.
- This level hit the yellow trend line for the second time and was soundly rejected. It also allowed us to extend the green line right across the chart where you can see it was broken with momentum and price tried to retest it.
- Price broke an extreme trend line (yellow), bounced from the green one before putting in a lower high and setting up a reversal pattern.
- This area had a convergence of lines including a failure test of a trend line before price pushed higher.
- This area has several trend lines broken, a consolidation at a trend line and then a decisive move lower.
How you use this information depends on how it speaks to you. Trend lines that are pushed out into the future can give you zones of opportunity when price reaches those areas. There are reversals, consolidations, momentum breaks…..quite a few ways to use this information to give yourself a strategy with at least a slight edge in the market.
1-2-3 Reversals With Trend Lines
I alluded to this a few times earlier but let’s look at this with greater detail. Trader Vic, as Sperandeo is better known, uses these to show a change of trend.
Here we have a market in an uptrend with a trend line on the lows. Price puts in a top and at #1, gives us our first condition: break of the trend line.
The market attempt to gain the high but fails to and now we have condition #2. Aggressive traders may start looking to short in this area.
Finally, we have our #3 condition and that is price taking out a minor low. A consistent method for determining the end of a trend.
You can even use these on smaller time frames to position yourself in the direction of a higher time frame trend. I will leave that for you to decipher but remember, a correction on a a higher time frame is a down trend on a lower time frame.
All we are really doing with trend lines is visually representing the rhythm of the market and are alerted to a change of state of the market when a trend line is broken. We then look to see if there is a pattern we can use to position in a trade in the right context.
A Few Simple Trend Lines Can Equal A Strategy
Learning to consistently draw trend lines is a skill you can easily master. It’s one thing though to master a technique but a different world to execute in real time.
Trend lines are certainly not foolproof but can give you zones where you can look for reversals/continuation of price to set yourself up in a trade.
Practice either of these ways of consistently applying a trend line and then spend the chart time to see how price reacts when it finds itself meeting one of them.