Drawing accurate trend lines lies at the heart of chart analysis. It looks easy but accurate trend line placement is more difficult than it appears at first glance. Accurate trend line placement, based on well-defined rules is the foundation of more complex analysis techniques. It is also the foundation of stop loss and risk management.
The temptation with trend lines is to plot them on a chart so that it prevents you from having to take unpleasant action. This includes closing a trade because it is losing money. Simply adjusting the position of the trend line allows you to convince yourself there is no need to close the trade. And the loss just grows and grows until it becomes too large to take under any circumstances. You ride the loss to the bottom, and sometimes to an ultimate de-listing of the stock.
Wishful thinking trend lines are also used to capture a trend breakout long after it has actually developed. The result is a late entry into a well-developed trend, often just before it collapses. The problem is not the analysis, but the placement of the trend line used for the analysis.
There are three fallacies about trend lines. The first is that a break above or below the trend line leads to an instant reversal of the trend. The trend line defines the current trend, but it does not define how the next trend will develop. This is one of the features that make breakout trading so dangerous with a high failure rate.
The second fallacy is the idea that a trend line must start from a pivot point low of the previous trend. In this application style the trader looks for the ultimate low point of the downtrend. He then uses this as an anchor point for the start of the new uptrend line. The trend line is designed to capture the bulk of the significant price activity. This is the major retreat and rebound points. Sometimes it is more appropriate to start the trend line with an anchor point that develops after the pivot point low of the previous trend.
The third fallacy is the idea that a firm trend line can be placed using just two points – an anchor point and a single touch point. This leads to some laughable, but exceptionally dangerous trend line placements. Dangerous because if you act on the analysis its an invitation to lose money. We discuss these issues in more detail in my new book . A trend line requires an anchor point and a minimum of two well-defined reaction points.
Consider the trend lines on this chart. The price activity at the right of the chart was laughingly described as “A clean break of a key downtrend.” Trend line A has an anchor point and a single touch point. Using this definition of the trend line we can also plot trend lines B through E. They are all incorrect because they do not define a change in the trend.
Our preference is to use a minimum of one anchor point and two additional touch and reaction points.
This is shown as trend line F. Using this analytical approach traders were able to join this trend breakout with NYMEX oilmuch earlier and with a higher level of certainty collecting a 100 percent profit before the incorrect signal was generated by trend line A.
Notice also how the new up trend line 1 defines the major retreat and rebound points and does not start from the ultimate low of the downtrend defined by trend line F.
These are the definition and placement rules we use for trend lines.
1. The line is placed along the lows of the price bars in a rising trend. The line is placed along the highs of the price bars in a falling trend.
2. The trend line starts with the extremes of the price bars—the high or the low.
3. The trend line should touch the maximum number of price bar extremes from the available choices. This means we do not exclude too many extremes, nor do we go for the maximum number of hits.
4. The more often a trend line is hit by price extremes, but not broken, the more powerful the trend line signal. When price does close beyond this it is a very strong trend change signal.
Trend lines are used for trend definition, but also as an integral part of some chart patterns. Good analysis, accurate placement, and the application of clearly defined construction rules take the guesswork out of trend lines and turn it into profitable analysis.
Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders –. He is a regular guest on CNBC's Asia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.
If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com. We welcome all questions, comments and requests.
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