"How to draw a trendline" is one of the first things people learn when they study technical analysis. Typically, they quickly move on to more advanced topics and too often discard this simplest of all technical tools. Yet you'd be amazed at the value a simple line can offer when you analyze a market. This article will explain the psychology of the trendline and how to use it the right way to improve your trading success.
"A trendline represents the psychology of the market, specifically, the psychology between the bulls and the bears. If the trendline slopes upward, the bulls are in control. If the trendline slopes downward, the bears are in control. Moreover, the actual angle or slope of a trendline can determine whether or not the market is extremely optimistic or extremely pessimistic."
In other words, a trendline can help you identify the market's trend and most importantly, a change of trend. For the beginning, let's understand why this matters.
The fastest and most risk-free way to make money in the markets is to identify a change of trend in a market as early as possible. Take your position (long or short), ride the trend, and close your position before or shortly after the trend reverses again. Any market professional will tell you that it is impossible to buy at the lows and sell at the highs (or sell at the highs and buy at the lows) consistently: but with practice, it is very possible to catch 60 to 80% of many intermediate-term and long-term market movements.
To be able to do this, you first have to know what the different markets are. what market instruments are available, where and how they are traded. what the margin requirements are, and so forth. Given this information, the next step is to identify a way to find specific markets that may be good investment opportunities.
To do this, you could go to the library and do three or four years of research on all the markets in the world, but by the time you finished your research, you would have forgotten half of what you learned and still have been broke. The other alternative is to learn to look at charts and analyze the trend.
Using candlestick charts or bar charts is the simplest and most effective way to analyze trends to pick potential buys and sells in any of the various markets. By learning a few simple techniques, you can look through as many as two or three hundred charts in an hour and pull out the roses from the slop. Then, with a more careful examination, you can pick the best of the best, and be left with a choice of five or ten markets that are worth doing some research on. When you go through these charts, what you are looking for is evidence of whether a specific forex pair, stock, an index or a commodity is likely to encounter a change of trend.
There are two important, and often overlooked, advantages in using charts for making speculative and investment decisions.
First, it is easier for most people to think in terms of visual images. Second, by setting concrete points of entry and exit according to the charts, you can more easily remain aloof from the emotional pressures which are so often confusing when money is at stake.
Bear in mind that the technical consistency of charts is best in the long term, slightly worse in the intermediate-term, and the most variable in the short term. Patterns on charts exist because market participants respond to similar conditions in similar ways.
Continue reading or play around in a risk-free demo account with the most advanced trendlines and trend analysis tools.
From the preceding section, we already know what a trend is. But to review, a trend is the prevailing direction of price movements within a given time period. In an upward trend, prices rise consistently over time interrupted only by temporary selloffs, which do not make lower lows than the previous sell-off. A downward trend is the converse of the upward trend-prices move consistently downwards interrupted by temporary rallies that do not make higher highs than the previous rallies. On the chart, trends appear as a sort of saw blade pattern, where prices make higher highs interrupted by higher lows on sell-offs during an uptrend, and lower lows interrupted by lower highs on rallies in a downtrend.
In analyzing a trend on the charts, the most useful tool is the trendline. One of the biggest mistakes made by amateurs and professionals alike is inconsistently defining and drawing the trendline. To be useful, the trendline must accurately reflect the definition of the trend. The method I have devised is very simple and very consistent. It fits both the definition of a trend and the inferences draw from Dow Theory pertaining to the elements of a change in trend:
Select the period of consideration: the long term (months to years), the intermediate-term (weeks to months), or short term (days to weeks). It can also be a smaller segment of any of these where a change of slope of the trendline is apparent.
For an uptrend within the period of consideration, draw a line from the lowest low, up and to the highest minor low point preceding the highest high so that the line does not pass through prices in between the two tow points (Figures 1 and 2 bellow). Extend the line upwards past the highest high point. It is possible that the line will go through prices past the highest minor high point. In fact, this is one indication of a change in trend, as will be demonstrated shortly.
FIGURE 1: Drawing the uptrend correctly - for an uptrend, draw the trendline from the lowest low to the lowest low preceding the highest high, without passing through prices between the two points.
FIGURE 2: Drawing the uptrend incorrectly - this trendline is wrong because, while it passes from the lowest low to the low preceding the highest high, it passes through prices between the two points. This mistake will result in a false indication of a possible change of trend.
For a downtrend within the period of consideration, draw a line from the highest high point to the lowest minor high point preceding the lowest low so that the line does not pass through prices in between the two high points. Extend the line past the lowest high point downward (Figures 3 and 4 belowe).
FIGURE 3: Drawing the downtrend correctly - for a downtrend, draw the line from the highest high to the highest high preceding the lowest low without passing through prices between the two points.
FIGURE 4: Drawing the trendline incorrectly - this trendline is wrong because it is drawn to a point which does not precede the lowest low. Note that while the trendline in the previous figure indicates a possible change of trend, this line doesn't give nearly as strong an indication. This demonstrates the importance of being consistent in drawing trendlines.
While this method is quite simple, it is extremely consistent and very accurate. The slope of this trendline is a close approximation to the slope you would get by doing a linear regression analysis on the price data over the same time period. Unlike other methods, it prevents you from drawing a trendline to suit your purposes-it prevents you from imposing your wish onto the trendline. It also provides the basis to graphically determine when a change of trend has occurred.
The ideal way to speculate is to buy at the bottom and sell at the top within a trend. Obviously, this is impossible to do with absolute consistency; the markets are too uncertain. But there is a way to determine technically when changes of trend have occurred so that you can catch 60 to 80% of most equities and commodity long-term price moves.
There are three basic changes in price movements that, when they occur in conjunction, define a change of trend in any market: forex, stocks, commodities, bonds everything. The changes are:
1. A trendline is broken. The prices cross the trendline drawn on the chart (Figure 5).
FIGURE 5: Breaking the intermediate trend line - the first indication of a change in trend is when prices break a properly drawn intermediate trendline. Condition 1 of the 1-2-3 change of trend criterion.
2. The trend stops making higher highs in an uptrend or lower lows in a downtrend. For example, in an uptrend after a minor sell-off, prices will rise again but fail to carry above the preceding high point or barely break the high and then fail. The converse would happen in a downtrend. This is often described as a "test" of the high or low point. This condition usually, but not always, occurs when a trend is in the process of changing. When it doesn't occur, price movements are almost always driven by important news, which causes prices to gap up or down and move erratically with relation to the "normal" price movement (Figure 6).
FIGURE 6: A test and failure of the previous intermediate high - the second indication of a change in trend occurs when prices approach but don't reach a previous high and then fail. Condition 2 of the 1-2-3 change of the trend criterion.
3. Prices go above a previous short-term minor rally high in a downtrend, or below a previous short-term minor sell-off low in an uptrend (Figure 7).
FIGURE 7: Price breaking below a previous intermediate low - the third and final indication of a change in trend occurs when prices break below a previous important minor low. Condition 3 of the 1-2-3 change of trend criterion.
At the point where all three of these events have occurred graphically, there exists the equivalent of a Dow Theory confirmation of a change of trend. Either of the first two conditions alone is evidence of a probable change in trend. Two out of three increases the probability of a change of trend. And three out of three defines a change of trend.
To watch for a change of trend on the charts, all you have to do is translate these principles to graphical terms as follows (refer back to Figures 5-7):
1. Draw the trendline as described above.
2. For a downtrend, draw a horizontal line through the currently established low point. Draw a second horizontal line through the immediately succeeding minor rally high.
3. For an uptrend, draw a horizontal line through the currently established high point. Draw a second horizontal line through the immediately preceding minor sell-off low.
Consider the case of an uptrend. If prices cross the trendline, mark the chart with a circled 1 at the point of crossing. If prices approach, touch, or slightly break the horizontal line corresponding to the current high and then fail to carry through, mark the chart with a circled 2 at that point. If prices carry through the line corresponding to the immediately preceding sell-off low, mark the chart with a circled 3 at that point. If two out of the three conditions are met, the chances are good that a change of trend will occur. If all three conditions are met, the trend change has occurred and is most likely to continue in its new direction.
After a little practice, you can learn to associate the three criteria of a change of trend visually and think of them in terms of 1-2-3: ( I ) a break in the trend line; (2) a test of the preceding high or low; (3) the breaking of a preceding minor rally high or minor sell-off low. It is as easy as I-2-3-the trend has changed!
Naturally, trading on these rules alone isn't 100% effective-no method is. Illiquid, news sensitive, and highly speculative markets like the forex market or cryptocurrency market and stock market are especially subject to sudden reversals (see Figure 7.9). If you trade on the I-2-3 criterion or any other change of trend criteria for that matter, and the market reverses, it is called "getting whipped" or "getting whipsawed." The best way to avoid being whipped, or to minimize your loss if you are whipped, is to follow these rules:
1. Trade only in highly liquid markets that historically aren't subject to sudden and large reversals. On the charts, illiquid markets are characterized by large price movements with sparse activity (Figure 7.8).
2. Avoid, if possible, highly news-sensitive markets or markets that are heavily subject to radical change from government monetary and fiscal intervention. The charts of such markets will be filled with "gaps"-large and sudden changes in prices with no prices printing in between the changes.
3. Take positions only when exit points can be set at previous resistance or support levels, which allow you to minimize losses if the market proves you wrong. These exit points are called "stop losses" if they accompany your order, or they can be set and executed yourself, which I call a mental stop.
Trading by the 1-2-3 criterion is a simple and effective method that, if applied carefully, works more often than not. One negative when trading by it is that by the time all three conditions are met, you sometimes miss a large portion of a price movement. There are other observations, however, that can aid you in deciding to take a position much earlier. One of them and my personal favorite is what I call the " 2B" criterion.
The best way to analyze the trend and identify a change of trend with higher odds of success was presented above, but there are traders who use trendline indicator to gauge the 'market feeling'. These trendline indicators can be:
Other traders go for an auto trendline indicator, which automatically identifies a trendline breakout based on some predefined rules. An auto trendline indicator is actually a Forex EA or Forex Robot.
Understanding how to use a trendline to analyze the trend and identify a change of trend as soon as possible is important, but if you need help MetaTrader 5 AM Broker offers some advanced tools for drawing trendlines, including trend and trendline indicators.
Additional, use an Expert Advisor Generator to create an auto trendline indicator with a few clicks without writing codes and test the signals of the backtested trendline indicator.