Provisionary(Tentative) and Confirmed(Valid) Trend-lines.
How to draw the trend-lines? A trend-line is created by projecting a line forward into the future drawn from two significant points. For uptrends, a line is drawn between two significant troughs and projected into the future, whereas for downtrends a line is drawn between two significant peaks and projected into the future. When drawing trend-lines, lines must not cut through any price action at any point along the line. A trendline is said to be only provisionary or tentative until it is tested for the first time, that is, at the third point of price contact on the trendline. Once tested, it is then regarded as a confirmed or valid trendline. All trend-lines are drawn between two points except for bullish support lines and bearish resistance lines in Point and Figure charting, where only one reference point is used. Fan lines use two points but only one point is located at a peak or trough, while the other is along a predetermined vertical axis. Note that the term tentative or valid is only applicable to conventional trend-lines and not to fan lines.
Short, Medium and Long Term Trend-lines.
A trend-line may be defined as short, medium or longer‐term depending on the amount of price activity it contains above or below it. Longer‐term uptrend lines
contain more price activity above them than shorter‐term uptrend lines. The converse is true for downtrend lines. See Figure 1.1
Figure 1.1 - Short Term, Medium Term & Long Term Trend-Line
Trend-line Support and Resistance: The Behavioral Component.
As mentioned in an earlier section, all price overlays, including trend lines, represent barriers to price action. As barriers, they provide support and resistance to price. Price approaching a trend-line from above will potentially experience support at the trendline, while price approaching a trendline from below will potentially experience resistance. This occurs because most market participants will usually place buy orders above a barrier and short orders below it. Hence, when price approaches the barrier from above, the initial triggering of buy orders will cause an upside reaction, creating temporary support. When price approaches the barrier
from below, the initial triggering of sell orders will cause a downside reaction, creating temporary resistance. As such, support and resistance are regarded as behavioural consequences of human psychology, biases, and emotions.
Invalidating and Redrawing Trend-lines.
A trend line is invalidated once it is breached. This does not mean that it is thereafter unusable or ineffective. The head and shoulders neckline is a popular example of a trendline being invalidated when the formation is confirmed, that is when the neckline is breached. Price very frequently retests the neckline after being breached. See Figure 1.2 for an example of an invalidated trendline and the redrawing of a new trend line. The new trend line is drawn between the new significant trough and the original lower trough in an uptrend. For downtrends, the new trend line is drawn between the new significant peak and the original higher peak. Once a trendline is invalidated, it is hereafter referred to as an internal line. So what actually constitutes a valid trend line penetration? The answer depends on the type and extent of filtering employed. If the trader were to apply the closing filter rule, then a valid trendline penetration would only be acknowledged once price closes beyond it. But what if price made a very significant intraday downside penetration but eventually closed back above an uptrend line? In such a situation, the penetration is usually regarded as significant but nevertheless invalid, based on the filtering rule employed. As we can see, the implications can be rather interesting.
Firgure 1.2 - Confirming and Invalidating Trendlines on the 30‐min Chart.
We yet again observe the problems with defining price action. The best way to resolve this dilemma is as follows:
■ Use only price‐based filters and avoid time‐ and event‐based filtering. This would allow the trader to decide exactly how much price excursion is required to represent a valid penetration of a trend line, or for that matter, any price barrier. Even if the amount of price excursion fails to be recognized as a valid penetration, this does not mean that a new trend line cannot be drawn. The trader will monitor price reactions at both the original and newly drawn trend-lines.
■ Use double‐stage filtering when employing time‐ or event‐based filters to gauge valid trendline or price barrier penetrations. As long as the second filter is price-based, the trader would be able to identify a valid penetration once the price exceeds a specified price. As before, this does not preclude the drawing of a new trend line, even if the intraday or intra‐period penetration has not exceeded the second filter’s validation price.
Elements of Trend-line Reliability.
What constitutes a reliable trend line? Quite simply, a reliable trend line may be defined as a trend line that provides consistent support and resistance to price action. A trend line that experiences a lot of whipsaws is considered unreliable. Factors influencing trend line reliability include:
■ The angle of trend line: A steep uptrend, that is, above 45 degrees, is usually regarded as less stable and may not be able to sustain itself over the longer term. Any trend line associated with such a trend is therefore deemed less reliable. A weak trend with a very shallow angle of ascent is also regarded as less stable and any trend line associated with such a trend is also deemed less reliable. The most reliable uptrend line is one where it the angle of ascent is approximately 35 to 45 degrees.
■ Duration of trend line: Longer‐term trend lines are generally regarded as more reliable than shorter‐term trend lines. A longer‐term trend line would have been in the market for a much longer period of time and would be more obvious to all market participants, be they short‐, medium‐, or longer‐term traders. As such, a longer‐term trend line will attract a larger number of buy orders above it and sell orders below it, and in the process transform into a stronger and more significant
barrier to price. This makes longer‐term trend lines more reliable. Longer‐term trend lines also attract the institutional players, resulting in larger orders placed at the trend line, giving rise to a stronger inhibiting effect with respect to price.
■ A number of price retests: The greater the number of retests a trend line experiences, the more indicative it is that traders are aware and paying attention to a trend line. Such a trend line will normally attract more orders around it as traders realize that it is rejecting price in a consistent manner.
■ The clarity of the price retests: The more precise the retest, the more indicative it is that the market participants are aware of such a trend line. As before, this
will attract more orders around the trend line, making it a more formidable barrier to price.
■ Confluence with other indicators: The more confluence or convergence there is with other bullish or bearish indicators at the point of contact on the trendline, the stronger will be the rejection of price at the trend line.
■ Preceding action: The contraction of cycle amplitude, cycle period, bar range, and body‐to‐range ratio are indications of a potentially weak uptrend and a potentially bullish downtrend. As such, this makes any trend line associated with such trends also suspect and unreliable over the longer term.
Strengths and Weaknesses of Trend line Analysis.
■ Trend lines, being straight lines, will catch any trend changes effectively.
■ Trend lines are able to identify trends without the need to identify specific price patterns and formations.
■ It is simple to construct and may be applied across all timeframes and markets with equal ease.
■ A trend line is viewable across all timeframes.
■ Trend lines, just like moving averages, are also subject to whipsaws and are less effective in erratic, volatile, or ranging markets.
■ Because trend lines are geometrically based overlays, they are affected by the type of scaling used, that is, ratio or linear.
Channels may also be created by projecting a trendline from a significant peak or trough that is parallel to the uptrend or downtrend line. Channels are useful in that they indicate potential:
■ Entry levels
■ Profit‐taking levels
■ Future price targets
■ Stoploss levels
Figure 1.3 illustrates the construction of a rising channel. First, draw an uptrend line based on two significant troughs, indicated at Points 1 and 2. Then locate a significant peak above the trendline, which in this case would be the peak at Point 3. Draw a line parallel to the uptrend line from the peak at Point 3 and project it upward. This projected line is called the channel or return line. This formation constitutes a rising channel. To draw a falling or declining channel, we first draw a downtrend line based on two significant peaks, indicated at Points 4 and 5. We then draw a line parallel to the downtrend line from a significant trough, indicated at Point 6, and project it downward. Notice that the trough at Point 6 has violated the uptrend line, which may be an early indication of a potential trend change. We see the rising channel transitioning into a falling channel.
Figure 1.3 - Channels and Channel Transitions.
Figure 1.4 shows stock price transitions within a larger rising channel. We say that the smaller channels are contained or nested within the larger channel. Channel nesting can occur at multiple levels, with large channels comprised of ever-decreasing channel sizes. In essence, channel nesting has fractal‐like properties.
Figure 1.4 - Nested Channel Transitions