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TREND LINE CONFIRMATIONS
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Up to now, we have covered basic as well as advanced techniques using the stochastics and MACD indicators and have demonstrated how they inte grate with each other, how candle patterns can help confirm trade signals

generated by these indicators, and how to use them in conjunction with pivot points. (We will go into more on this subject as we examine building a trading system in Chapter 8.) One simple technique that is an enormous help that you should use to confirm potential trend reversals and trading opportunities is using simple trend line analysis. When combined with either stochastics or MACD trade signals, as we have just learned, applying simple trend line techniques can help you not only identify but also confirm entry as well as exit levels. Pivot points will give you a heads-up on a target level to watch in a given time period; the indicators can help you identify if a trend is weakening, especially in a convergence or divergence situation arises. Then, by applying simple trend line analysis, you can really deter mine your entries and build on a trading opportunity.

Drawing trend lines is extremely important for the hands-on trader. If you need to look at the charts rather than relying on automatically gener ated trading signals, then this is a must for you. Trend lines not only serve as identifying support and resistance levels but also quickly identify reversal points and shifts in momentum, otherwise stated as changes in price di rection. Simple trend line analysis can help you determine if prices move too far, too fast, if they are in what I call a hyperbolic unsustainable ex treme price move, which we see with very steep trend lines drawn. If the market moves sideways or tries to trend higher, we see a low-angle or flat trend line. The best trend to follow is when prices move along a 45-degree angle. This is a healthy development and indicates a sustainable move. In an uptrend, prices should move up and bounce against the support trend line for a good period of time.

With this angle, you should expect a nice price advance. Therefore, it will help you demonstrate patience in order to allow the trade to mature to maximize profits. Figure 5.12 shows the three categories of trend condi tions in a bullish mode; the opposite would be true for downtrends. Always remember that the 45-degree angle is the ideal trend formation. This is how you want prices to trend when you want to stay with a trade. As the old say ing goes, the trend is your friend; any trend that is too steep can also be your friend, as long as you do not over stay your welcome.

In order to determine when a bullish market officially makes a trend line break, I like to use the lower closing low and the two-period close rule, as we went over earlier, to confirm that prices have indeed signaled an im minent price change or an early warning of a trend reversal. Here is how I use trend line breaks combined with stochastics or MACD indicators to help identify trading opportunities:

• I want to see lower closing lows from one or two prior time periods.

• I want to see confirmation of a price change with two consecutive closes below a support line.

Let's examine Figure 5.13. Focus on point A along the chart. The price graph in the top section of the chart shows the peak in prices as formed by a shooting star candle. See how that peak is higher than the past 10 ses sions' high. The corresponding points as referred to in the middle section of the chart is the fast stochastic indicator, where we see prices making a higher high but the indicator has a lower low (bearish divergence). The

bottom section is the MACD indicator that does not show the moving aver age component illustrating a divergence pattern. However, the histogram component shows declining bars; and as the market breaks and closes not one but two time periods below the trend line, see how a zero-line cross is confirmed in the MACD histogram? Here is how you would trade this setup. You identify the market moving higher and draw a support line under the series of lows. You have ample clues that the bullish condition is weaken ing as the momentum indicators signal the bearish divergence pattern. What really highlights this sell signal is the fact that the %K and the %D com ponents of the stochastics have met our criteria, as they have now crossed and closed back below the 80 percent level. Once prices close for the second period below the trend line, you would sell at the market. Your stop loss order can be one of several choices

Place a hard stop above the high formed by the shooting star candle.

2. Place a mental stop-close-only order above the high, and use a trailing stop method once the market moves in the desired price direction.

3. Use a time condition set so that if you do not see performance of the trade as desired within two to three time periods, you will exit the po sition at the market.

As you can see in the figure, once prices break and establish two con secutive closes below the upward support line, a sell signal would be triggered. At this time, we see immediate results follow as prices move in the desired direction and condition. By this, I mean we see lower highs, lower lows, and new lower closing lows. The trade is seeing positive results al most immediately.

Let's step back a moment now and start from the beginning. Compare Figure 5.13 to Figure 5.14, where I have added pivot points and the Defcon III indicators. With the moving averages overlaid, combined with the pre dicted pivot support levels and the added candle patterns highlighting a high close doji buy signal, we could look at drawing a supportive trend line from the lows as prices advance. Let's say you took the buy signal in the euro and followed the move up. Notice that the arrow triggering the exit or a new short position occurs at point A. Notice also that prices have not closed below the support line by two consecutive time periods, but a sell signal was triggered.

If you entered a buy at 128.40 and used a hard stop below the low of the doji, using the aid of the stochastics oscillator and/or the MACD, both indi cators were confirming to stay long until the signal to sell occurs at point A. Once we see the moving average system signal a sell, stochastics confirms with an 80 percent line cross by the %K and %D lines. The MACD follows one bar later. The moving average component of MACD and the zero-line cross coincide with the second close below the trend line as well. If you can learn to spot these triggers and act on these specific patterns and sequence of events, especially as the divergence warns, you will see significant im provement in your bottom line

MAKING GOOD USE OF TREND LINES

Let's make good use of learning the importance of trend line analysis as it corroborates other techniques in technical analysis. We previously looked at when the market peaked. Then we took a step back and studied the pat tern and trade signal from buy to sell. Now let's follow the progress of the last sell signal. Figure 5.15 shows how we drew the resistance trend line from the peak, or the highest point made from the shooting star at 129.40, and extended it out to the first reactionary high at 128.80 and then shifted the line all the way to the right of the chart

SUMMARY

Stochastics is used to identify that a trend has reversed or that a new cycle phase has developed. MACD signals are given after a market has moved in a new trend; therefore, this indicator is mostly used as a confirmation tool, rather than as a trigger tool. Finding a setup pattern that meets your trade objectives from your entry, the loss or risk factor as well as the exit plan can all be achieved using the steps we have disclosed in the book up to this point. The most important factor is that you trade based on a defined set of rules, mostly using the guidelines and theories presented so far. Following trend and mean reversion techniques can be rewarding when you stick to a game plan. However, no matter how well you execute a trading decision, you need to manage and monitor the trade and base your exit strategy within the time frame or price objectives dictated by the market. Indicators, trend lines, and pivot points, as great as they are, only go so far.

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