Trendline trading – Everything you need to know
Veteran traders will agree that trendline trading forms an integral part of their trading system. Novice traders appreciate them due to their simplicity of drawing the trendlines, effectiveness to reflect the underlying price trends, the reflection of trend strength, and ability to confirm trend reversals. While trendlines can be traded independently, they also form the basis for a wide variety of other technical forex trading strategies.
Contents
- What is a trend line
- How to draw best trendlines
- Validation of a Trendline
- Best time frames for trendline trading
- Types of trendline forex trading
- Trendline trading strategy- Trend Continuation
- Analyzing strength using Angles and Slopes
- Trendline breakout trading strategy
- Trendlines in other strategies and patterns
- Limitations
- Conclusion
What is a trend line:
A Trend line is a straight line drawn on the chart connecting consecutive swing lows or consecutive swing highs. This straight-line provides the trader with the current direction of the price movement and the potential future direction. Trend lines provide a better understanding of the trend visually, enabling the trader not only to enter the markets in the direction of the trend but also to trade in the countertrend direction. Trendlines provide an insight into the strength of the trend and also provide an early warning of the impending weakness of the current trend.
How to draw best trendlines:
Trendlines can be drawn by connecting the consecutive price highs or consecutive price lows. However, the trendlines are very effective when connecting the consecutive swing points of the price.
It’s important to identify the swing points first to connect them. The above image shows a swing high, a swing high is formed by 3 consecutive candles with the middle candle having a higher closing price than the closing prices of the candles on either side. In the above picture, the Swing high is formed by 3 candles A, B, and C, the closing price of B is higher than the closing prices of candles A and C effectively forming a swing high. The opposite goes to swing low which consists of 3 consecutive candles with the low of the middle candle closing lower than those on either side.
A down trendline is formed by connecting the consecutive swing highs, an uptrend line is formed by connecting the consecutive swing lows.
Picture B shows the construction of a downtrend line by connecting 2 consecutive swing highs, the effective line formed is the downtrend line. It’s important to note that the trendline should not be breached in between the 2 consecutive swing points, in other words, the prices should not have a candle closing above the trendline in between the swing points in a down trendline
Picture C shows the construction of an uptrend line formed by connecting the swing low points A and B. The line formed shows provides the uptrend line also note that the prices should not breach the trendline in between the swing points.
Validation of a Trendline:
A trend line once formed can be validated to make it stronger support or resistance. In Picture D, a trendline is formed by connecting the consecutive swing highs A and B, this is further validated by the inability of the prices to break the trendline and move higher, this validation of the trendline by the 3rd swing high makes the trendline stronger. All trendlines are a representation of support and resistance. A swing high B the buyers fail to push the prices higher than swing high A, this forms the trendline. Buyers try again to push the prices higher at swing point C and fail to post higher prices than swing point B, this displays the underlying strength of the sellers and validates the trendline.
Best time frames for trendline trading:
Trendlines can be drawn in any time frame, they work with the same efficiency across the time frames be it the 1 minute time chart or a weekly or monthly chart. Trend traders use the trendlines in the higher timeframe to identify the bigger trends and use the smaller timeframe trendlines to find out better entry points in the direction of the bigger trend. This enables the trader to place orders in the direction of the larger trend and to stay in the direction of the trend.
Types of trendline forex trading:
Most trend following indicators or strategies enables the traders to trade in the direction of the trend. But, Trendlines can be used to identify successful trades both in the direction of the trend and counter-trend direction. Traders use these lines to get a better understanding of the support and resistance levels areas within the price chart, this provides a general idea of the market structure in a top-down analysis. Example: If an uptrend is identified in a Daily chart, the trader can look for uptrends in an H4 chart or an H1 chart, effectively trading a larger timeframe trend in a smaller timeframe chart. Trendline support and resistance levels form an important basis for trend trading and counter-trend trading strategies.
All forms of support and resistance, including trendlines, can be breached depending upon the market sentiments. During a bull market if buyers gain strength there is a fair chance that prices will breach the resistance lines, no matter how strong the trendline is or how many times the trendline is validated. The opposite of this is true in a bear market sellers tend to breach the uptrend lines.
When prices touch the trend lines they present 2 opportunities to the trader, if prices are unable to breach the trend line then we expect a trend continuation, on the other hand, a trend reversal is expected if prices breakthrough.
Trendline trading strategy- Trend Continuation:
Trendlines provide the trader with an opportunity to enter the market with the best possible price and ride the trend.
The above picture shows a GBPUSD M30 chart, the prices following an uptrend line. The trader uses the first 2 swing points to construct the trendline, upon the construction of the trendline most traders will prepare a trading plan and would wait for the prices to fall back and retouch the trendline again. Since the trader anticipates the prices to continue the trend, they place a Buy limit order 5 pips below the trendline, this will result in a trade with the best possible entry price.
In the above picture, the traders first identify the swing points, then construct the trendline. Once the trendline is drawn they prepare the trade plan to place a sell limit order, thereby entering the market with the best possible selling price.
There is a possibility, the momentum of the prices may carry the prices and breach the trendlines momentarily and then retrace back again to continue in the direction of the trend. These price movements are identified as false breaks, false breaks should be inspected and validated using price action trading.
Analyzing strength using Angles and Slopes:
Trendlines not only provide support and resistance levels, and better entry points, but they also provide reveal the strength and weakness of a trend. Trendlines are drawn sloped or at angles, the study of these angles and the slope provide the trader with additional important insights.
If the slope and angle of the trendline are very acute, then prices tend to move very sharp which could result in the prices moving far from the current level. Trendlines with a wider angle or slope will tend to have weaker price movements. Once the trend produces trendlines with a lower slope or much wider angles, this signals the trader that the trend is weakening and may end soon, upon this signal the trader may decide to book partial profits or exit the trade.
In the above Picture G, the trendline with an angle of -28 degrees has a lower slope and represents a larger trend. There are 2 more trendlines with an angle of -44 and -62 degrees respectively. Picture G illustrates that the trendline with -62 degrees provides much sharper move and price displacement than the trendline with a lower degree comparatively.
Trendline breakout trading strategy:
It is imperative that the trend once formed may not continue forever, trends change due to the change in the strength of the buyers and sellers of the underlying asset. Every trader understands trend reversal is possible at any given time and should accommodate a strategy for reversal and plan accordingly.
A trendline breakout happens once the price closes below an uptrend line or closes above the downtrend line. Breakouts invalidate a trendline and signal a reversal of trend direction.
Picture H illustrates a trendline breakout trading. Once swing low A and swing B are connected a trendline is formed. At point C the price breaches the trendline lower and the candle makes a closing price lower than the trendline. This is further validated by the next candle by opening and closing below the trendline.
The up trendline was acting as a support for the trend, once the trend line is broken this transforms as resistance and acts as a downtrend line. Now the trader has new information and will prepare a trading plan to enter the markets in the direction of the newly formed trend. Best traders wait for the best prices to enter, they avoid entering the markets at any given price level to ride a trend.
In the above Picture H, the best strategy to look for a place to enter the market is to wait for a pullback at point D, prices touch the trendline.
The strategy to place a trade in an established trend and, placing a trade in a newly formed trend is different. A newly formed trend needs further study and validation before entering the markets. In Picture H, the trader will wait for further confirmation of the trend reversal at point D by studying the price action or candlestick pattern to confirm the trend reversal, and then decide to place a trade based upon the price action. It is strongly recommended to validate a change of trend using price actions in the next available lower time frame, failure to do so may result in the trader reacting too early and getting caught in fake reversal signals.
Trendlines in other strategies and patterns:
Trendlines form the basis for many other strategies and patterns and are used extensively not only to form patterns but also to validate them.
Head and shoulders, down channel, up channel, flags, pennants, falling wedges, rising wedges, ascending triangle, descending triangle, symmetrical triangle, and other similar patterns use the trendlines both for formation and validation
Limitations:
Trendlines are subjective. Traders not only use swing points but may also choose to use any of the parameters of open, high, low, or close to drawing the lines. Due to its ease of construction traders ignore to connect the lines properly and fit them as they anticipate it. Given the same chart to a set of traders, they may draw the trend lines.
Market structure and price momentum during sustained price pressure particularly during an economic news release may create price spikes and may result in candles closing the opposite side of the trendlines. These scenarios may warrant the trader to place a trade believing the change in direction of a trend, though they may last momentarily. Identifying false breakouts are an important part of identifying price reversals and form an integral part of trend line trading, many traders seem to ignore additional confirmation using price action.
Conclusion:
Almost all traders would have constructed a trendline for one reason or other during their trading. The simplicity makes it a handy tool for everyday use, it is of no doubt that trendline is a friend of the trend. Trendline trading strategies if used carefully and properly in confluence with price action will result in a successful and rewarding trading strategy.
