01What Trendlines Do
Trendlines highlight a trend or range (sideways movement). A trendline connects swing lows and swing highs in price. When the price is rising, the swing lows rise. Connecting these lows with a line results in an ascending trendline, showing the trend is up. A trendline can also be drawn along the swing highs. This shows the angle of ascent, and whether the price is moving strongly higher or not (see Analyzing Price Action: Velocity and Magnitude)..
When the price is falling, the swing highs fall. Connecting these highs with a line results in a descending trendline, showing the trend is down. A trendline can also be drawn along the swing lows. This shows the angle of descent, and whether the price is moving strongly lower or not. Click for larger image.
02Multiple Trendlines (Trends) at One Time
There is never just one trendline in play. At any given moment you could draw many trendlines, all showing how the price is moving over various periods of time.
Trendlines at very steep angles are typically short-lived, since price cannot sustain a near vertical rise or fall for long. That said, drawing trendlines whenever possible can aid new traders in spotting the overall trend, while also highlighting small trends and corrections within that overall trend. For more see What Time Frames to Watch While Day Trading Stocks.
During an uptrend, buying opportunities 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. Click for larger image.
Once drawn, trendlines often need to be adjusted. Price doesn't usually move in a uniform fashion, and since trendlines account for both time and price (they move along the price and time axis) any acceleration of deceleration of the trend will require the trendline to be adjusted.
Earlier it was stated trendlines are a tool, and can't be relied on solely. To decide whether a trendline should be adjusted, or whether it has been definitely broken, consider how the price moves within a trend.
During an uptrend the price makes higher highs and higher lows (see Impulsive and Corrective Waves). As long as that is occurring, if the price moves below a trendline it doesn't necessarily mean the trend is over, the line may just need to be adjusted.
During a downtrend the price makes lower lows and lower highs. As long as that is occurring, if the price moves above the descending trendline it doesn't necessarily mean the trend is over, the trendline may just need to be adjusted. Click for larger image.
04Trendlines Are A Guide
When it come to trading, trendlines are a helpful guide. They alert you to potential trade areas, such as in figure 2, when the short-term trend meets the longer-term trend. Though, as the section above discussed, trendlines often need adjusting, making a trendline imprecise for using as a trade signal. Also consider that a trendline drawn at a slightly different angle can make a big difference on what price that trendline intersects with.
Therefore, use trendlines as a guide, but use a more precise criteria for entering a trade, such as move back in the trending direction (see Day Trading Trending Strategy), an engulfing pattern, or an indicator which adjusts more precisely (and quickly) to changes in volatility.
If trendlines are just a guide, then we don't need to concern ourselves with drawing trendlines along exact highs or lows. Draw "trendlines of best fit." The best fit trendlines still provide us with a visual trend and alert us to potential trade areas (see How to Spot Trading Opportunities).
In some cases drawing trendlines along extreme highs and lows works, but when it doesn't, draw trendlines of best fit. Since the trendline isn't being used as a trade signal, it still provides you with relevant information about the trend, without the need to constantly readjust it (although some adjustment may still be required). Click for larger image.
How to Effectively Use Trendlines in Your Trading
Trendlines are a useful tool, but often misused
Trendlines, and how to supposedly use them is one of the first things many new traders learn when delving into technical analysis and trading off of charts.
Trendlines are an excellent tool, if used effectively. Used improperly though, they become ineffective, resulting in a belief a reversal is underway when it is isn't, or that a trend is still strong when price action suggests it isn't. Here are some things you need to know about effectively using trendlines in your trading.