What are trendlines and how can you use them in your trading?
Traders who use technical analysis routinely swear by trendlines as an important means to determine market movements. So how can you use trendlines in your daily trading activity, and what do the different types of trendline tell you?
Do you have the power of prediction?
Nobody can accurately predict exact price movements in the market, but there are ways to gauge market sentiment by using a combination of technical and fundamental analysis. One of the most beneficial tools employed by traders is the trendline, giving you a simple means to view the general direction of prices over time.
In their simplest form, trendlines are used to plot the upward, downward or sideways direction of a series of prices for the market: a commodity, currency pair, stock or index. By connecting up several prices over time, it is possible to create a trendline.
When you follow a particular trendline – bullish, bearish or neutral – you can anticipate future price movements of the tradable asset. This will give you a good idea as to the overall direction of market prices in the future. While not a guarantee, trendlines are useful indicators of likely market sentiment.
Trendlines can be measured over multiple timeframes – short-term, medium-term and long-term. When you understand the trend’s direction, you are better poised to place successful trades. As mentioned earlier, there is no guarantee that the trend will continue – but the fact that it is a trend is a good indication that it will.
Trendline gradients: what you should know
The two most important trendline directions that you need to focus on as a trader are uptrends and downtrends. These terms describe the direction of the slope from left to right. As you move further left on the X-axis, you’re moving back in time, and as you move up along the Y-axis, prices are increasing.
A downward-sloping trendline from left to right indicates that prices have been falling over time. It also indicates excess supply – meaning that demand is weak. If the tradable asset that you are considering features a downward-sloping trendline, avoid taking a long position on that asset. In other words bearish positions are probably best.
By contrast, an upward-sloping trendline from left to right indicates that over time the price of the asset is increasing. This indicates that demand is strong and the tradable asset has good future prospects. Taking a long position in such an instance is the right idea. Bullish sentiment is generally associated with upward-sloping trendlines.
We can generally assume that with an upward-sloping trendline demand will continue to improve as will the price of the asset. But when you’re looking at a trendline you must be careful not to fall into the trap of distortion. What appears to be a strong trend may only be an incredibly short-term movement that has been extrapolated onto a graph.
Always look at the timeline when you are examining trendlines: the shorter the timeline the less reliable the trend for future price movements.
Flat gradient trendlines
It sometimes occurs that a graph will not show any upward or downward movement in its trendline. In this case it is possible that prices are moving in a tight (range-bound) pattern. This typically occurs when low volatility exists with stable supply, demand and prices. During this trading period, prices tend to consolidate.
The price of the tradable asset in this instance will not display large fluctuations at all, although horizontal trendlines tend to be a harbinger of a future uptrend or downtrend. The reason for this is that a period of price consolidation typically needs to take place before prices move sharply higher or sharply lower.
Determining support/resistance levels with trendlines
A support level is a foundation which tends to be resistant to further price drops. A resistance level is a ceiling which tends to be resistant to price increases. Stocks, commodities, indices and currency pairs tend to trade within a range between support and resistance levels. If you’re the type of trader looking for an entry point into the market, you will be particularly interested in the importance of support/resistance levels.
Historically speaking, support levels tend to provide support to the price of the stock – in other words the price tends to stay above the support level. Buyers come into the market at a specific support level. A resistance level is simply a price level that the stock finds it difficult to break through.
It is not always easy to accurately draw a trendline, since it is difficult to know which prices to include and which prices to exclude. The fact of the matter is that a trader must use his or her own discretion, or defer to the advice of guru traders when it comes to charts and graphs with trendlines. There are opening prices, closing prices, high prices and low prices that can be used in generating trendlines.
With positive trendlines, support levels are typically used, while negative trendlines typically use resistance levels. It must be remembered that, regardless of their gradient, the more times the price touches the trendline the more important that trendline becomes. This should encourage you to place your limit order higher on upward-sloping trendlines – to secure as much profit as possible. The converse also holds true on the downside.
Support and resistance levels are good indicators of whether or not a trend will continue. This is a strategic approach to take when trading assets. There is no hard and fast rule about which price points to use, but the number of times that the price touches the trendline is significant.
Published: 22 July 2015
You should under no circumstances consider the information and comments provided as an offer or solicitation to invest. This is not investment advice. The information provided is believed to be accurate at the date the information is produced.