Technical Analysis – Trendlines

Trendlines are the most basic concept in the technical analysis field. A trendline is the line of a trend, and we all know by now that “The trend is your friend”. How do we know that a trend is broken and is about to reverse? Clue: When the trendline is broken, or when its line is not showing anymore, a continuation in the same direction. Trendlines are a tricky thing to use in charting the Forex market. Everybody knows about them, but few can correctly draw them. Below are a few things to consider before applying a trendline onto a chart:

How to Use a Trendline

A trendline is a valuable tool when riding a trend. It shows clear support and resistance levels, and therefore offers places to enter a trend that has already started, or to add to a position that is open.

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Use Trendlines to Find Out Dynamic Support/Resistance Levels

Depending on the timeframe they are drawn on, trendlines are strong support and resistance levels. A trendline is never a horizontal line, and this makes the support/resistance level more powerful than a static/horizontal one. Please refer to the previous articles dedicated to classical and dynamic support and resistance levels before proceeding, as the information provided there is valuable moving forward. To make a trendline, at least two points are needed. Connecting these points and dragging the line forward onto the right-hand side of the chart means that we’re projecting future support/resistance levels that the market will meet. After all, this is what technical analysis is: interpreting information on the left-hand side of the chart to predict levels on the right-hand side; in other words, making a forecast based on the information already known.

You probably remember the EUR/USD chart that we used for illustrating the dynamic support and resistance levels a few articles before this one. The trading set-up called for a rising wedge pattern that just broke the lower trendline, which proved to be support; and at that moment support turned into resistance. From the previous levels within the wedge formation, support and resistance levels, classical ones, were derived. However, the rising trendline of the wedge was the trendline that defined the bullish trend. It was formed by connecting two points and dragging the trendline onto the right-hand side of the chart. That dynamic support and resistance area that followed was derived from projecting the trendline beyond the connection of those two points.
Trendlines -1
In the meantime, in the period in between, the price broke the trendline, indicating that the bullish trend had ended, and retested it. This retest shows the interchange between the support and resistance levels on a dynamic area. Classical support levels did the trick moving forward, but the key to this reversal was the trendline that had been broken and retested. As you can see in the chart above, after the retest came, there was nothing in the way of the newly born trend, as the market moved with few or no retracements.

Key Stays with the Lower-Highs and Higher-Lows Series

When dealing with trendlines, the key stays with the higher-lows series (in the case of a bullish trend that is about to start) or with the lower-highs series (in the case of a bearish trend that is forming). In both instances, either at the start or the end of a trend, these series are the ones that make the difference between the right or wrong interpretation of a trendline. As a rule of thumb, if the trendline of a bullish trend is broken, but the higher-lows series is continuing and is not broken, chances are that the break of the trendline was a fake one, and should therefore be discounted. In this case, if the market makes a new high, it means the trend still has power in it, and to benefit from the extra juice it provides, a new trendline that reflects the new conditions must be drawn.

The above comes as proof that trendlines must adapt to ever-changing market conditions. The same is valid in the case of a bearish trend. It is of no importance that the trendline is pierced or broken by a swing higher if the lower-highs series is still intact. If price action is reversing, and the market makes a new low when compared with the one that is already in place, it means that the overall trend is not completed, and we’re in for a trend continuation. As such, the trendline must adapt to the new conditions. So what’s to be done if the trendline is broken and the lower-highs and higher-lows series are broken as well? In this case, it is a clear sign that the previous trend is over, and it is time to build the trendline for the new one. The chart above shows that the previous lower-highs series that defined the bullish trend has been broken, and from that moment on there was no turning back. The next thing to do is to draw a trendline that connects the newly created lower-highs series. This is the line of the new bearish trend, and, if conditions mentioned above are in place, there is no reason to abandon the trend or to look for a reversal.

Riding a trend is every trader’s dream, but doing such a thing is unfortunately not that easy. Things like market psychology and the way it affects human nature, as well as patience, greed and fear, all have a say in the profitability of a trade. While technical analysis uses logic to predict future prices and offers clear sets of rules with which to ride a trend, human nature makes it difficult to follow the trading plan. This is one of the reasons why so many traders fail to succeed when trading the Forex market. There’s more about market psychology and money management to come in future articles here in our Trading Academy. For now, keep in mind that even simple and basic things like a trendline are enough to make the difference between a trader who struggles and one who succeeds.

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