Definition: A line drawn connecting a series of lower pivot highs (downtrend line) or a series of higher pivot lows (uptrend line) to illustrate the prevailing direction of price.
Trend lines are a visual representation of support and resistance in any time frame and are used to show direction and speed up price. Trend lines can also be used to illustrate patterns during periods of price consolidation.
As we have seen, one of the principles that technical analysis is based on is that prices move in trends. These trends can be up, down or sideways (range). But trends are best defined by not using trend lines. Trend lines are not good at tracing the parabolic nature of a strong bull or bear market. Often you can draw several steeper lines during a sustained move. When is the trend over? When the first trend line is broken? The second? The third? You are forced onto a subjective opinion.
A better way to define the trend is by using the simple definition: while a market is making higher highs and higher lows, it is in a bull trend. While a market is making lower highs and lower lows, it is in a bear trend. A sideways market reflects horizontal price movements, where there is no consistent pattern with the highs or lows.
Trends can be brief or be around for a long time. Traders try to determine when prices are in an uptrend or downtrend. They profit by determining the trend and then following it until it is revered. Of the many charting tools available, the trend line is most widely used by technicians to identify trends and trend reversals.
How Trend lines are Drawn
Drawing trend lines is easy. A trend line is simply a straight line that connects a series of prices, either tops or bottoms. An uptrend line is a straight line that connects a series of reaction lows. Note that a trend line appears at the bottom of the price pattern and is drawn up and to the right.
A downtrend line is a straight line that connects a series of rally tops. Note that the trend line “pushes” the market down… a line down below a downtrend, supposedly “pulling” the market down has no relevance or validity.
There are a number of guidelines which should be observed, firstly to ensure that trend lines are drawn correctly and then evaluate the strength of significance of a particular trend line. First of all, there must be at least three tops or bottoms to begin a trend line. These tops or bottoms are called ‘pivot points’. The latest bar cannot be the third point because the lasted bar has not yet formed a pivot point.
Significance of a Trend Line
The significance of a trend line is determined by two factors, namely the number of points (tops or bottoms) that the trend line touches and the length of time the trend line has persisted without being broken.
Each time prices move back to an uptrend line then renew their advance (or move back to a downtrend line and continue their decline), the significance of the trend line is enhanced.
The number of bars that make up the pivots touching the line adds to the importance of the line. For example, if there are four lower bars each side of each pivot, the resulting trend line has more importance than one with only two lower bars either side of the pivot point.
The length of the trend line indicates the period of time that prices have remained above or below the trend line. Obviously, the longer the period the greater the significance of the trend line. For example, a trend line that has not been broken for 10 weeks is more significant than one that has held for 10 days or 10 hours.
In addition to the number of points that touch a trend line and the length of time the trend line has persisted, technicians feel the angle of the trend line adds to the signfincae of a trend line.
In general, the closer to horizontal the more significant any break will be. Very steep trend lines can easily be broken by brief sideways consolidation moves; trend lines that are less steep are not subject to many short term price movements (that are often inconsistent with the current trend).
Filters – Confirmation of a Trend Line Break
Once a trend line has been established, a change in direction of the trend is signaled by prices breaking through the trend line.
Four criteria are used to determine the validity of a trend line break.
This relates to the extent of the break – how far prices have moved past the trend line. There is no right answer to the question;
How far do prices have to move before the trend line break is valid? It unfortunately depends on the volatility of the asset. For instance a break in bitcoin could be considerably different to a break in GBP/USD.
In your trading strategy you may decide that a break is a certain amount of pips above or below the trend line, once that number has been hit then you would execute the trade, either manually or with an automatic order.
Some analysts use the close of a period of time, either a candlestick or bar depending on the chart you’re using. If the price closes above or below the trend line then this is considered a break
The notable thing about a time filter is that the market should not have closed above or below the price prior to the break otherwise it just shows that this trend can break and it can be a false break.
The validity of a trend line break is enhanced if it is accompanied by expanding volume (especially when downtrend lines are broken). However, it is not essential for volume to increase for there to be a valid break. In other words, the extent of penetration is more important than its volume characteristics.
Is the break accompanied by a long bar or a gap? If so, then it is rare for the break to prove false. When an asset trades unusually actively following a trend line break you can consider this as the market confirming the break. In these situations buying high or selling low or even getting slippage can be a good thing because it indicates that the market is moving strongly in that direction.
Trend Line Reversal
Once a trend line is broken, it normally changes its role from either support to resistance (for an uptrend line) or vice versa. Note that prices first moved away from the trend line, then back to it, then away again. This is called a pullback or return move and is not uncommon. Pullbacks offer traders great entry points for buying or selling.
There are two good reasons why you should consider entering a trade on the pull back;
- The break has already confirmed the direction
- You may get a better price during the pullback rather than jumping in during the break
In many instances, prices repeatedly move about the same distance away from a trend line before returning to the trend line. In these cases, a second line can be drawn (parallel to the trend line) connecting the peaks of rallies in an uptrend or the bottoms of declines in a downtrend.
That line is called a return or channel line. The trend line together with the channel line create a trend channel, a range within which prices are moving. A channel is the most natural way for a market to go from ‘A’ to ‘B’ when no new news hits the market.
Well defined trend channels appear most frequently in charts of actively traded markets. Thinly traded markets offer little opportunity for trend channels to develop. Trend channels can be used in many fashions. Analysts use trend channels to determine good profit taking levels. For example, in an uptrend, they may sell an asset when it approaches the upper level of its trend channel.
More experienced analysts watch price movements within the two boundary lines of the trend channel looking for a warning signal that the trend direction is changing. If, in an upward trend channel, prices rally up from the trend line but fail to reach the upper channel line, it signals a deterioration of the trend and probability that the lower line will be broken.
Frequently the distance from the top of the failed rally to the channel line equals the distance by which the next move down breaks the trend line.
Similarly, in a downtrend trend channel, if prices drop from the trend line but fail to reach the bottom channel line, it signals a deterioration of the trend and probability that the upper line will be broken. Likewise, the distance from the bottom of the failed attempt to reach the channel line to the channel line often is equal to the distance by which the next rally breaks the trend line.
Trend channels can be used in another way. if prices break through the upper lone in a upward trend channel, an acceleration of the exisiting uptrend is signaled. At this point, some traders will add to their position. Likewise, if the price moves through the bottom line of a downward trend channel, the existing downtrend is picking up speed and short positions may be increased here.
Classically, the target from a trend channel break is a move equal to the width of the channel. This is often a conservative target, as the market can continue to run given the momentum.
In an uptrend, a trend reversal occurs when prices are held at resistance. You will then begin to see reversal signals, either in the pattern of the market, candlesticks or secondary indicators.
A trend reversal occurs in a downtrend when prices are unable to break a support level (due to increased demand absorbing all available supply). In this case, a bottom reversal pattern is formed and the trend changes direction to the upside.
Keep in mind that a trend reversal is not signalled by the first failure to break through a resistance level (in an uptrend) or a support level (in a downtrend). A reversal pattern must fully develop before you get the signal that the trend has changed. In other words, a trader should not rush to get rid of their position just because the price has held at resistance.
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