Chapter 6: Trendlines PDF

TRENDLINES Trendlines are perhaps the simplest of the tools we use in the technical arsenal and are arguably one of the most effective. Since the construction of nearly all price patterns requires the use of trendlines, this concept is a fundamental building block of pattern identification and inter...

TRENDLINES Trendlines are perhaps the simplest of the tools we use in the technical arsenal and are arguably one of the most effective. Since the construction of nearly all price patterns requires the use of trendlines, this concept is a fundamental building block of pattern identification and interpretation. A trendline is a straight line connecting either a series of ascending bottoms in a rising market or the tops of a descending series of rally peaks. Those joining the lows are called up trendlines, and those connecting the tops are referred to as down trendlines. It is also possible to construct horizontal trendlines joining a series of identical lows or identical highs. Typically, a down trendline is constructed by joining the final peak with the top of the first rally, as in Figure 6.1. Loading… Major Technical Principle A true trendline is a graphic way of representing the underlying trend. Loading… Ideally, an up trendline is constructed by connecting the final low with the first bottom in the rally, as line AD in Figure 6.5. This is called the primary trendline. In the case of a primary trend, this would be the bear market low and the first intermediate bottom. The example shown here offers a fairly shallow angle of ascent. Unfortunately, the price rallies sharply, which means that the violation develops well after the final peak. In such situations, it is better to redraw the line as the price moves up. Major Technical Principle Drawing trendlines is more a matter of common sense rather than following a set of hard-and-fast rules. Trendline Breaks Can Be Followed by a Reversal or Consolidation The completion of a price pattern can signify either: (1) a reversal in the previous trend—in this instance, it is known as a reversal pattern; or (2) a resumption of the previous trend, when it is called a consolidation or continuation pattern. Similarly, the penetration of a trendline will result in either a reversal of that trend or its continuation. Figure 6.6 illustrates this point from the aspect of a rising price trend. Loading… The upward price trend and trendline penetration in Figure 6.7 are identical to those in Figure 6.6, but the action following this warning signal is entirely different. A third alternative is that the price consolidates in a sideways trading range and then advances (Figure 6.8). Finally, it may consolidate and then reverse to the downside. This is shown in Figure 6.9. In a rising market, a trendline penetration may occur at the time of, or just before, the successful completion of a reversal pattern. An example is shown in Figure 6.10. Figure 6.11 illustrates the same phenomenon from the aspect of a bear market reversal. If the violation occurs simultaneously with, or just after, the completion of a reversal pattern, the two breaks have the effect of reinforcing each other. Sometimes, as in Figure 6.12, the trendline violation occurs before the completion of the pattern. Major Technical Principle As a general rule, the violation of trendlines with a sharp angle of ascent or descent is more likely to result in a consolidation than a reversal. Extended Trendlines Figure 6.13 shows a trendline reversing its previous role as support while the throwback move turns it into an area of resistance. Figure 6.14 shows the same situation for a declining market. Logarithmic (Ratio) vs. Arithmetic Scales Scaling is an issue that is often overlooked in the technical community, but since it can have an important influence on how trendlines can be interpreted, this is as good a place as any to introduce this concept. There are two axes on any market chart. The x axis, along the bottom, registers the date (except in point and figure charting), and the y axis, the price. There are two methods of plotting the y axis: arithmetic and logarithmic. Which one is chosen can have very important implications. Arithmetic charts allocate a specific point or dollar amount to a given vertical distance. Thus, in Chart 6.3, each arrow has the same vertical distance and reflects approximately 250 points. That will be true at any price level. A logarithmic scale, on the other hand, allocates a given percentage price move to a specific vertical distance. In Chart 6.4, each arrow represents a move of approximately 100 percent, whether it is at lower prices or higher prices. Significance of Trendlines It has been established that a break in trend caused by the penetration of a trendline results in either an actual trend reversal or a slowing in the pace of the trend. Although it may not always be possible to assess which of these alternatives will develop, it is still important to understand the significance of a trendline penetration; the following guidelines should help in evaluation. Length of the Line The size or length of a trend is an important factor, as with price patterns. If a series of ascending bottoms occurs over a 3- to 4-week span, the resulting trendline is only of minor importance. If the trend extends over a period of 1 to 3 years, however, its violation marks a significant juncture point. Just remember: Big trends result in big signals, small trends in small signals. Number of Times the Trendline Has Been Touched or Approached A trendline also derives its authority from the number of times it has been touched or approached; i.e., the larger the number, the greater the significance. This is true because a trendline represents a dynamic area of support or resistance. Each successive “test” of the line contributes to the importance of this support or resistance, and thus the authority of the line is a true reflection of the underlying trend. Just remember that a close encounter to the line (an approach) is almost as important as an actual touching because it still reflects the line’s importance as a support or resistance area. Angle of Ascent or Descent A very sharp trend, as in Figure 6.15, is difficult to maintain and is liable to be broken rather easily, even by a short sideways movement. All trends are eventually violated, but the steeper ones are likely to be ruptured more quickly. The violation of a particularly steep trend is not as significant as that of a more gradual one. Trend Channels So far, only the possibilities of drawing trendlines joining bottoms in rising markets and tops in declining ones have been examined. It is also useful to draw lines that are parallel to those basic trendlines, as shown in Figure 6.21. In a rising market, the parallel line known as a return trendline joins the tops of rallies, and during declines, the return line joins the series of bottoms (see Figure 6.22). The area between these trend extremities is known as a trend channel. Loading… In Figure 6.23, the violation of the return line signifies that the price advance has begun to accelerate. In effect, the channel in Figure 6.23 represents a rising trading range, and the trendline violation is a breakout from it.