Trendlines are a key part of delving into technical analysis and trading off of charts. When used correctly, they're a helpful, clear, and relatively simple tool for traders. Used improperly, however, trendlines become ineffective and even counterproductive. Knowing how to use trendlines can be the difference between winning and losing trades.
Keep reading to learn some tips that can help you effectively use trendlines as part of your trading strategy.
The Basics of Trendlines
Trendlines are simply diagonal lines that highlight a trend or price range. These lines follow the price movement in an attempt to give traders a general sense of how high or low the price might go in a given timeframe. When the price rises, the trendline rises accordingly. When the price falls, the trendline falls.
When prices are rising, connecting the lows with a line results in an ascending trendline—an "uptrend." A trendline can also be drawn along the highs of the trend. This shows the angle of ascent, the strength of the price move, and the relative strength of the trend.
When the price falls, the highs fall. Connecting these falling highs results in a descending trendline—a "downtrend." A trendline can also be drawn along the lows to highlight the angle of descent and the strength of the downward price movement.
Using Multiple Trendlines
Typically, you would have more than just one trendline in play. At any given moment you could draw many trendlines, all showing the price movement over various periods of time.
Trendlines at steep angles typically have short lives, since prices cannot sustain a near-vertical rise or fall for long. Shallower trendlines are more stable and easier to maintain.
Drawing trendlines whenever possible and on multiple time frames can aid new traders in spotting the overall trend, small trends, and corrections within those small trends.
During an uptrend, opportunities to buy or go long may occur when a short-term downtrend meets the overall ascending trendline. During a downtrend, selling or shorting opportunities may occur when a short-term uptrend meets the overall descending trendline.
Once drawn, trendlines often need to be adjusted. Prices rarely move uniformly for a prolonged period. This means any acceleration or deceleration of the trend requires adjustments to the trendline.
To figure out whether your trendline needs adjusting, watch for any instances when the price breaks through your lines. If the price moves below your trendline in an uptrend, then you need to adjust your line. The same goes for downtrends when the price moves above the trendline.
Keep in mind that adjusting a trendline doesn't mean the trend has changed. An uptrend is characterized by higher highs and higher lows, and as long as those keep happening, it's still an uptrend. You may find that you adjust your trendlines several times within a single uptrend.
Trendlines As a Guide
The need for constant adjusting makes a trendline imprecise for use as a trade signal. Consider that a trendline drawn at a slightly different angle can make a big difference in what price that trendline intersects with over time.
While you can use trendlines as a guide, you must use more precise criteria for determining when to enter or exit a trade. These criteria could include a certain size move back in the trending direction, a trigger based on an engulfing pattern (where the next bar is larger than the previous one, engulfing it), or another type of indicator that adjusts more precisely and quickly to changes in volatility.
If you use trendlines as just a guide, then you don't need to worry about drawing trendlines along the exact highs or lows. Draw "trendlines of best fit"—the ones that provide visual clues about potential trade areas.
Since the trendline isn't being used as a specific trade signal, rough trendlines can provide you with relevant information about the trend without forcing you to readjust it constantly.
The Bottom Line
Trendlines are a great tool for showcasing short-term trends within the overall trend. Pay attention to price action, and always consider it when using trendlines. If the price makes lower lows and lower highs, it's still a downtrend—even if the price moves above a descending trendline. If the price makes higher highs and higher lows, the price still has an uptrend even if it moves below the trendline.
A trendline needs to be adjusted often, especially when day trading. Use a "trendline of best fit" to avoid constantly adjusting. It still shows the trend and when the trend may be reversing.
Use trendlines to alert you of potential trade opportunities, and use price action signals to determine exactly how to seize those opportunities.
Frequently Asked Questions (FAQs)
What does a trendline tell you?
A trendline gives you approximate areas of support and resistance. These trends aren't exact, and they aren't foolproof, but they remind you of areas where price has reacted several times in the past. When current market trends persist, trendlines serve as helpful guides that can be combined with other technical analysis tools to plan trade entries and exits.
How do you draw a trendline?
To draw a trendline, find the "drawing tools" section on whatever charting software you're using. This will be the section that contains trendlines, Fibonacci retracements, and other drawing-related technical analysis tools. Select the "trendline" option, then draw a straight line that connects peaks to other peaks (or troughs to other troughs). The more touches you can get on the trendline, the more valid that trend becomes.