Technical Analysis – Trend lines
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 it 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 them, but few can correctly draw some. Below are a few things to consider BEFORE applying a trendline on a chart:
- It CAN be broken by parts of the trend, without invalidating the trend.
- It is NOT mandatory to be drawn from the start of the trend
- Look for a series of higher-lows or lower-highs as the potential start of a trend, hence as the moment we can draw a trend line.
How to Use a Trendline
A trendline is a valuable tool when riding a trend. It shows clear support and resistance levels, therefore offers places to enter a trend that already started or to add to a position that is opened.
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Use Trendlines to Find Out Dynamic Support/Resistance Levels
Depending on the timeframe they are drawn, 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 moving forward. The information provided is valuable moving forward. For a trendline, at least two points are needed. Connecting these points and dragging the line forward on the right side of the chart, means that we’re projecting future support/resistance levels the market will meet. After all, this is what technical analysis is: interpreting information on the left side of the chart to find out levels on the left side. In other words, making a forecast based on the already known info. You probably remember the EURUSD chart that we used for illustrating the dynamic support and resistance levels a few articles before this one. The trading setup called for a rising wedge pattern that just broke the lower trendline that 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 connecting two points and dragging the trendline on the right side of the chart. That dynamic support and resistance area that followed was derived from projecting the trendline after those two points were connected.
In the meantime, in the period in between, price broke the trendline, indicating the bullish trend ended and retested it. This retest shows the interchanging 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 has 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 little or no retracements.
Key Stays with 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 one (in the case of a bearish trend that forms). In both instances, either at the start or 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. Therefore, it should be discounted. In this case, if the market makes a new high, it means the trend has still power in it and to benefit from the extra juice it provides, a new trendline that adapts to the new conditions must be drawn. This comes as a proof that trend lines must adapt to ever-changing market conditions. The same is valid in the case of a bearish trend. It has 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 the overall trend is not completed and we’re in for a trend continuation. As such, the trendline must be adapt to the new conditions. What’s to do if the trendline is broken and the lower-highs and higher-lows series are broken as well? In this case, this is a clear sign the previous trend is done and it is time to build the trendline for the new one. The chart above shows the previous lower-highs series that defined the bullish trend has been broken and from that moment on it 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. Doing such a thing is not that easy, unfortunately. Things like market psychology and the way it affects human nature, as well as patience, greed or fear – they all have a saying on the profitability of a trade. While technical analysis uses logic to predict future prices and offers clear sets of rules 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. 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 that struggles and one that succeeds.
Recommended Further Readings
- Forex Trading – Explaining the Concept
– What is forex trading, generalities about trading the currency market.
- Why Trading Forex?
– Advantages and disadvantages of trading the currency market, what are trader’s expectations and what is a realistic approach to follow
- What is a Forex Broker and Types of Brokerage houses
– Explaining what a Forex broker is and does, how the business should be organized, and how many types of Forex brokers exist.
- Financial Products to Trade
– Different categories of financial products that a Forex Broker is offering for the retail clients, starting with the classical currency pairs, and continuing with commodities, CFD’s, indexes, etc.
- Forex Trading Sessions and Their Importance
– Explaining the differences between the three Forex trading sessions, what are their importance, ranking, etc.
- Forex Brokers Types – ECN or STP?
– What is ECN, STP, how d- brokers deal with client’s orders, advantages, and disadvantages of the tw- types.
Other Educational Materials
- “Naive trading rules in financial markets and wiener-kolmogorov prediction theory: a study of” technical analysis” Neftci, Salih N. Journal of Business (1991): 549-571.
- “Technical analysis in the foreign exchange market: a layman’s guide.” Neely, Christopher J. Review 79 (1997).