Providing the trendlines are drawn correctly, they can be highly advantageous in helping the trader to successfully analyse financial markets.
Trendlines be used to determine whether a currency pair, stock, commodity or crypto-currency is up-trending or down-trending. They can be useful in helping the professional trader to select potential buy or sell levels.
Some professional technical traders use trendline analysis exclusively, both for their technical analysis in addition to selecting their trade’s entry and exit points. Many experienced traders, however, use trendlines in conjunction with other modes of technical analysis in order to come to an informed trading decision. These can include horizontal levels, moving averages, pivots and Fibonacci retracements.
In this trading lesson, we will explain what trendlines are, how to use trendlines to identify chart patterns in addition to how to draw trendlines so that you can independently select good trade set-ups; generally buys in up-trends and sell set-ups in down-trends.
It is important to remember that there is widespread misunderstanding with both using and drawing trendlines correctly. This can have an adverse impact on the trader’s ability to dissect and read the chart. Therefore, it is essential for you to understand trendline analysis correctly in order to know how to play the odds in trading.
Put simply, a trendline is a line which is drawn to connect swing highs (peaks) and swing lows (troughs) in order to give the trend following trader a clear picture of the prevailing direction of price over time (Y and X axis respectively). They are particularly useful for technical traders as they can clearly reveal technical clues such as significant points of support or resistance, and where potential opportunities may lie in the future.
For example, for the trend trader, this may simply be “buying a dip” in an uptrend or “selling the rally” in a down-trending market.
How we draw our trendlines depends on whether we are in an uptrend or downtrend, as they are drawn at a sloping angle (below price), connecting key swing lows or troughs. (trend line trendline support). Conversely, in an downtrend, the trend line is drawn at a sloping angle which is (above price), connecting key swing highs. This is also known as trendline resistance.
In order for a trendline to be considered “valid”, we need the candle-sticks or OHLC bars to touch or “test” the trendline at least three times. This is essential.
The above forex chart (EURNZD) reveals an “up-trend”. The trendline has been drawn to connect the “swing lows” on multiple occasions and therefore can be referred to be “trend line support”.
As price action has tested this trendline five times, it will be presumed by the forex trader that it is likely that price is likely to test it again at some point in the future.
The above forex chart (EURJPY) reveals an “down-trend”. The trendline has been drawn to connect the “swing highs” on multiple occasions and therefore can be referred to be trend line resistance.
As price has tested this trendline six times, it is likely it will be tested for a seventh time in the future.
Many traders make the mistake of thinking that two tests validate the trendline. They do not. Two tests are merely a coincidence! The all-important third test gives us the confirmation and this is the difference between a valid trend and merely a fluke. This is contrary to many forex trader beliefs.
Two tests do not validate a trendline – they’re merely a coincidence!
Three tests confirms a trendline – after the third test, it is valid:
Remember, drawing trendlines can and is very subjective. The forex chart below will show you the different ways trendlines can be drawn.
Question: Which colour trend line do you suppose is correct?
Answer: They all are! Let me explain!
The orange trendline has five tests, breaking on the fifth occasion price came to touch it. You will notice that this trendline has some spikes below it. These are known as “false breakouts”. As long as the bar which went below the trendline actually closes above the trendline, it is valid. If the bar closes below the line, then the trendline then becomes invalid.. This happened on the fifth test.
The green trendline has three tests, so is valid, with price whiplashing against the line, before closing below it after the third test.
The black trendline is the strongest out of the three, as it is the most long-term. It has three tests so validates itself as a trendline on the third test.
Tip: The more obvious and long-term the trendline is, the stronger it is. Drawing trendlines is very subjective so if you will likely find that someone else’s trendlines are drawn very differently to yours.
After the third bounce on the trendline and the trendline has been confirmed, we now have the probabilities stacked in our favour. As the trendline has held for three tests, it is highly likely that the trendline support or resistance will hold if price comes back to for the fourth time.
As technical traders, it is important to trade with probabilities on our side. It is therefore essential that we trade with the trend as we will be trading with the smart money.
In a bull market, when price action is trendline upwards, we can obtain an efficient buy entry by simply “buying the dip”. We can do this on the “fourth test”, when price comes back to test the trendline after the trendline has been confirmed.
Chart: GBPAUD Daily
In a bear market, when price action is trendline downwards, we can obtain an efficient sell entry by simply “selling the rally”. We can do this on the “fourth test”, when price comes back to test the trendline after the trendline has been confirmed.
Chart: Silver Weekly
Professional traders will wait for price to travel to the trendline and will only trade if they receive a confirmation or trade signal. This could include a price action based set-up, such as a pin bar reversal.
See article: How to Trade Pin Bar Reversals
If the pro trader is looking to buy the bounce in an uptrend, they will only trade if the market gives them a bullish pin bar reversal on the fourth bounce or after. Conversely, in a downtrend, the trader will only look to trade after a pullback if a bearish pin bar reversal closes after a pullback.
The break of a trendline is the first sign that the trend is coming to an end and this serves as an early warning sign for trend traders. However, it is important to recognise the difference between false breakouts and confirmed trendline breaks.
The break of the trendline is confirmed when price moves through it and closes above or below it, depending on whether it is in a downtrend or uptrend respectively.
The chart below reveals the trendline break on the fourth bounce, just after the trendline has been confirmed. As price has traveled through the trendline support and closed below it, the trendline is now invalid. After the close below the trendline in an uptrending market, it is likely the market to continue downwards.
The chart below reveals the trendline break. This is confirmed as soon as price closes above the trendline resistance. The trendline is now, therefore, negated. It is likely that price will move upwards.
False breakouts are frequent, and not to be confused with the trendline break. In a downtrend, these occur when price temporarily moves above the trendline but closes below it. In an uptrend, a false breakout would manifest itself with price moving below the trendline temporarily, but will close above it.
Trendline analysis is a great technical method used to determine the momentum a trending market has. The steeper the angle of the trendline, the stronger the trend is said to be. Three bounces confirms the trendline and it is valid until the trendline support or resistance breaks. The opportunity to buy or sell occurs on the fourth bounce. The break of the trendline is confirmed when price action closes either below it (if a trendline for an -uptrend) or above it (if a trendline in a down-trend) and this is an overt warning that the trend has come to an end.
Trendlines are useful for the technical trader in an to identifying where future trading opportunities may occur. These can include buying the trendline bounce in an up-trend or selling the bounce in a down-trend. However, the act of drawing trendlines can be subjective in its nature and this could entice the trader to use other forms of technical analysis.
Knowing how to use trendlines is a useful skill and especially powerful when used in conjunction with other forms of technical analysis. A thorough understanding of it will certainly help you become a more proficient trader.