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TRENDLINES, How To Draw a Trendline, Trendline Breaks
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Charts reveal the actions of bulls and bears. Bottoms of declines show where bears stopped and bulls regained control of the market. Peaks of rallies show where bulls ran out of steam and bears gained control. A line connecting two nearby bottoms shows the lowest common denominator of bullish power. A line that connects two nearby tops shows the lowest common denominator of the power of bears. Those lines are called trendlines. Traders use them to identify trends.

When prices rally, draw an uptrendline across the bottoms. When prices decline, draw a downtrendline across the tops. Projecting those lines into the future helps anticipate buying and selling points.

The most important feature of a trendline is its angle — it identifies the dominant market force. When a trendline points up, it shows that bulls are in control. Then it pays to buy with a protective stop below the trendline. When a trendline points down, it shows that bears are in control. Then it pays to sell short and protect your position with a stop above the trendline.

Trendlines are among the oldest tools of traders. Modern computerized tools for identifying trends include moving averages, the Directional system, and MACD (Chapter 4).

How to Draw a Trendline

Most chartists draw a trendline through extreme high and low points, but it is better to draw it through the edges of congestion areas (Figure 21-1). Those edges show where the majority of traders have reversed direction. Technical analysis is poll-taking — and polltakers want to track opinions of masses, not of a few extremists. Drawing trendlines through the edges of congestion areas is somewhat subjective. You have to watch out for the temptation to slant your ruler.

Panic dumping by bulls at the bottoms and panic covering by bears at the tops create extremes, which appear as long "tails" on the charts. You want to base your trendlines on the edges of congestion areas and not on tails because tails show little about the crowd other than its tendency to panic.

The extreme points are very important—but not for drawing trendlines. Markets usually recoil from those tails, offering opportunities to short-term traders (Figure 21-1). As Steidlmayer pointed out, a bar that looks like a finger sticking out of a tight chart pattern provides a valuable reference point for short-term traders.

Markets constantly fluctuate, seeking an area that generates the highest volume of trading. A tail shows that a certain price has been rejected by the market. It usually leads to a swing in the opposite direction. As soon as you recognize a tail, trade against it. Place your protective stop halfway through the tail. If the market starts "chewing its tail," it is time to get out.

Victor Sperandeo described another method for drawing trendlines in his book, Trader Vic. His technique helps identify reversals of well-established trends (Figure 21-2).

Sperandeo draws an uptrendline from the lowest low of the move to the Draw trendlines through the edges of congestion areas and leave out the extreme prices. Tails are long bars at the ends of trends-they spring outside of congestion areas. Markets recoil from tails, offering good trading opportunities in the opposite direction.

Notice how the angles of uptrends tend to recur, month after month. Knowing this can help you draw preliminary trendlines. At the right edge of the chart, prices are touching their uptrendline-buy as soon as you see a bar that fails to reach a new low.

highest minor low prior to the highest high. That line may not pass through prices between those two points. When that trendline is broken, it gives the first signal of a trend change. The second signal is given when prices retest the recent high and back away from it. The third signal occurs when prices break through the previous minor low. It confirms that the uptrend has reversed. A mirror image of this method applies to downtrends.

Rating Trendlines

The single most important feature of a trendline is its slope. When a trend-line slants up, bulls are in control and it pays to look for buying opportunities

Draw a trendline from the highest high (A) to the highest minor high (B) preceding the lowest low (C) so that it does not pass through prices between A and B. The break of this trendline (1) is the first signal of a trend change. A test of the recent low (2) gives the second signal of a trend change. This is a good time to start buying. When prices break through their minor high (3), they will confirm that the trend has reversed. This method, described by Victor Sperandeo, helps catch major reversals rather than shorter-term swings.

When a trendline slants down, bears are in control and it pays to look for shorting opportunities. You can rate the importance of any trendline by examining five factors: the timeframe of the trendline, its length, the number of times prices touch it, its angle, and volume.

The longer the timeframe, the more important the trendline. A trendline on a weekly chart identifies a more important trend than a daily trendline. A trendline on a daily chart identifies a more important trend than an hourly trendline, and so on.

The longer the trendline, the more valid it is. A short trendline reflects mass behavior over a short period. A longer trendline reflects mass behavior over a longer time. The longer a trend continues, the greater its inertia. A major bull market may follow its trendline for several years.

The more contacts between prices and trendline, the more valid that line.

When the trend is up, a return to the trendline shows a rebellion among bears. When the trend is down, a rally to the trendline shows a rebellion by the bulls. When prices pull back to a trendline and then bounce away from it, you know that the dominant market group has beaten the rebels.

A preliminary trendline is drawn across only two points. Three points of contact make that line more valid. Four or five points of contact show that the dominant market crowd is firmly in control.

The angle between a trendline and the horizontal axis reflects the emotional intensity of the dominant market crowd. A steep trendline shows that the dominant crowd is moving rapidly. A relatively flat trendline shows that the dominant crowd is moving slowly. A shallow trendline is likely to last longer, like a turtle racing against a hare.

It pays to measure the angle of every trendline and write it down on your chart (Figure 21-1). This can be done using a computer, a protractor, or a Chinese Charting Tool. Comparing angles of trendlines shows whether the dominant market crowd is becoming more bullish or bearish. It is uncanny how often trendlines trace the same angle time and again in a given market. It may be because the key players seldom change.

Sometimes prices accelerate away from their trendline. Then you can draw a new, steeper trendline. It shows that a trend is speeding up, becoming unsustainable (Figure 21-3). When you draw a new, steeper trendline, tighten your stop, place it immediately below the latest trendline, and adjust that stop at every new bar. The breaking of a steep trendline is usually followed by a sharp reversal.

When the trend is up, volume normally expands when prices rally and shrinks when they decline. This shows that rallies attract traders while declines leave them cold. The opposite occurs in downtrends —volume expands on declines and shrinks on rallies. A pullback on heavy volume threatens a trendline because it shows that the rebellious crowd is growing.

If volume expands when prices move in the direction of a trendline, it confirms that trendline; if volume shrinks when prices pull back to a trendline, it also confirms the trendline. If volume expands when prices return to a trend- line, it warns of a potential break; if volume shrinks when prices pull away from a trendline, it warns that the trendline is in danger.

Trendline Breaks

The breaking of a well-established trendline shows that the dominant market crowd has lost its power. You have to be careful not to anticipate trading signals—most traders lose money when they jump the gun.

The stock market rose slowly but steadily from its 1987 bottom. You could buy each time prices touched their shallow uptrendline (1). The uptrend accelerated in 1988, and at point A, a new uptrendline (2) had to be drawn. When the new, steeper trendline was broken, it indicated that the bull move was over. The market offered, as it sometimes does, an excellent shorting opportunity at point B, when it pulled back to its old uptrendline before crashing.

A trendline is not a glass floor under the market —one crack and it is gone. It is more like a fence that bulls or bears can lean on. They can even violate it a bit without toppling it, the way animals shake a fence. A trendline break is valid only if prices close on the other side of a trendline. Some traders insist that a trendline has to be penetrated by two or three percentage points of price ($8-$12 in the case of $400/oz. gold).

After a very steep uptrend is broken, prices often rally again, retest their old high, and touch their old uptrendline from below (Figures 20-2, 21-3). When that happens, you have a near-perfect shorting opportunity: a combi­nation of a double top, a pullback to an old trendline, and perhaps a bearish divergence from technical indicators. The reverse also applies to downtrends

Trading Rules

•  Trade in the direction of the slope of a trendline. If it points up, look
for buying opportunities and avoid shorting. When the slope is down,
trade from the short side and avoid buying.

•  A trendline provides support or resistance. When prices rise, place buy
orders at the uptrendline and protective orders below. Reverse the pro­
cedure in downtrends.

•  Steep trendlines precede sharp breaks. If a trendline is steeper than
45°, place your stop right at the trendline and adjust it daily.

•  Prices often retest their latest extreme after breaking a steep trendline.
A pullback rally to an old high on falling volume and with indicator
divergences provides an excellent shorting opportunity. A decline to
an old low after a downtrendline is broken provides a low-risk buying
opportunity.

•  Draw a channel line parallel to a trendline and use it as a target for
profit taking.

Trendline Channels

A channel consists of two parallel lines that contain prices (Figure 21-4). If you draw an uptrendline across the bottoms of reactions, you can draw a channel line parallel to it across the tops of rallies. When you draw a down­trendline across the tops of rallies, you can also draw a channel line parallel to it across the bottoms of declines.

Channel lines, like trendlines, should be drawn across the edges of congestion areas, leaving out the extreme highs and lows. The presence of a channel line reinforces the validity of the trendline itself. The validity of channel lines depends on how many times they were touched by prices.

A channel line marks the area of bulls' maximum power in an uptrend and bears' maximum power in a downtrend. The wider the channel, the stronger the trend. It pays to trade in the direction of the channel's slope, going long in the lower quarter or half of a rising channel and selling short in the upper quarter or half of a falling channel. Profits should be taken at the opposite channel wall (see also Section 45).

Figure 21-4. Trendline Channels and Preliminary Trendlines

The downtrendline 1, drawn across rally peaks, identifies a bear market in corn. A channel line 2 is drawn across the lows, parallel to the trend- line. The channel line helps track the maximum power of bears in a downtrend. The best shorting opportunities are in the upper half of a falling channel, while the best buying opportunities are in the lower half of a rising channel.

When prices break out above their downtrendline, channels can help you draw a preliminary uptrendline. First, draw a new channel line 3 to connect the last two rally tops. Then draw line 4 parallel to it, touching the latest bottom. This is the new preliminary uptrendline.

At the right edge of the chart, corn is trending higher. It is expensive-near its upper channel line. If you want to go long, place an order to buy in the vicinity of the new uptrendline 4.

A Preliminary Trendline

Normally, a trendline touches at least two points on a chart. There is a little-known technique for drawing a preliminary trendline through only one point (Figure 21-4).

When prices break their downtrend and rally above it, you can assume that the downtrend has ended and a new uptrend may begin. Connect the two latest peaks — this is the channel line of the new uptrend. Draw a line parallel to it through the latest low. This preliminary uptrendline, drawn parallel to a channel line, tells you where to expect the next bottom. It often points to excellent buying opportunities. This procedure tends to work better at bottoms than at the tops.

More on Trendlines

When prices break their uptrend, measure the vertical distance from the trendline to the latest top and project it down from the breaking point. If the crowd can become optimistic enough to swing prices so many dollars above the trendline, then it is likely to become equally pessimistic and swing prices the same distance down from the trendline. Reverse this procedure in down­trends. This method gives you the minimum target for a new move, which is often exceeded.

Trendlines can also be applied to volume and to indicators. The slope of a trendline of volume shows whether more or fewer people are becoming involved in the market. A rising trendline of volume confirms the current price trend. A falling trendline of volume shows that the market crowd is refusing to follow the current price trend. Among technical indicators, the Relative Strength Index (see Section 31) is especially well suited for trendline analysis. It often breaks its trendlines in advance of prices, providing an early warning of a trend change.

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