Trendlines are one of the most basic building blocks of technical analysis. As the term suggests, a trendline is a line that is used to identify a developing or established investment trend.
Support versus Resistance Trendlines
There are two types of trendlines: support and resistance. A support trendline is one that you believe will hold up against movement in the opposite direction of your position. For instance, a bullish investor believes a support trendline protects against movement below the level of the line. A resistance line exists where you connect multiple price points above the existing level.
To place a trendline, you identify at least two, but ideally three, points in an investment pattern. The sooner you can recognize an evolving trendline, the better able you are to determine your ideal entry point. The general rule of thumb is that two points allow you to create a trendline, but the third point that holds up when testing your trendline validates it. A safe trading approach is to lean into the trendline for entry, and place a stop-loss order on the other side in case your the line doesn’t hold.
Trendline Testing and Validation
The more times a trendline is tested, the more it has been validated by the market. Trendlines reinforce a key reason why technical analysis is real; they create a self-fulfilling prophecy because large and small investors alike use them to determine entry and exit points. For instance, if you have enough investors who believe a support trendline will hold because of a bullish outlook, those investors create the support and validation of the line. The same point applies if the line is resistance, and you have bullish investors exiting and short-traders entering.
A trendline break occurs when a security trades above or below your established line. A break is also said to invalidate the line as support or resistance since it didn’t hold up under testing. In truth, most trendlines break at some point because of a trend correction or reversal.
You also have short-term trends and trendlines that function within long-term trends. For instance, a day trader looks at a more narrow price and time scope than a swing trader, and both take much more narrow views than long-term investors. Within a long-term pattern in a security, it is common to have a well-established trendline, yet find many broken lines within shorter time-frames. The lines you draw need to fit your determined trading or investing strategy and intended time to hold.
Trendline Accuracy Matters
Accuracy matters when creating trendlines. On a short-term position, an inaccurate line could cause you to miss an entry or ideal exit from your position. It is even more crucial, at times, to miss a trendline point on a long-term chart. As patterns play out, that narrow miss on a high or low point could escalate in significance months or years later.
Fortunately, most advanced brokers and charting tools allow you to snap your trendlines to price points, which helps reduce potential for human error. Some of these programs are frustrating to use, though, as the lines may snap to other points outside of your intended view. I typically prefer to manually place lines, but to ensure accuracy, I zoom in on each line point to validate the point-touch accuracy with the line. Accuracy on small mobile device screens is especially tricky; I prefer to do more thorough trend analysis on a larger desktop screen.
Practice Drawing Trendlines
The best way to learn to apply trendlines is to practice. Choose any security and identify a couple points in a current pattern formation, either short or long-term. Place your line. Watch the action to see if your line holds up.
The meaning of trendline validation can vary depending on your chart styles and approach. “Line” charts mark the closing price points within your time frame (15-minute, 30-minute, hourly, daily, weekly, monthly). Candlestick charts have candle bodies that mark the opening and closing prices within the time-frame, but have candle shadows and tails that denote intra-period highs and lows. In a short-term strategy, such as day trading, placing lines at the end of candle wicks (shadows and tails) is essential to account for intra-day trends. However, long-term investors may opt to use a line chart that shows trends based on closing prices, or may place lines that run along the bottom or top of the candle body. This topic is involving enough to have more thorough coverage in a separate post.
Understanding trendlines is one of the first steps to beginner education in technical analysis. Trendlines establish whether a security is trending up, down or sideways during a particular period, and contribute to optimum entries and exits.
If you are ready, the next step is to learn about trading channels!