Introduction to Technical Analysis Part 3: Trendlines
Trendlines
Trendlines are harder to visualise than support and resistance lines. They are diagonal lines that either define an area of support in the market or an area of resistance. It identifies the current trend of a market and a break of the trendline indicates either a reversal or a retracement in that trend.
An uptrend is a succession of higher highs and higher lows and a downtrend is a succession of lower highs and lower lows.
It is very important to draw a trendline correctly. Unlike a support or resistance line, two points are needed to draw a trendline but a third point is needed to confirm it. The more touches and the longer the trendline has been in place the more important it is.
In an uptrend a line is drawn connecting the lows to form a trendline. This is because the buyers in market are pushing the market in an uptrend. As analysts we are not looking to sell at the top of a market, we are looking to buy into an uptrend. We need to know that following a period of retracement back to the supporting trendline buyers reenter the market and push the market back up. If this fails to happen, then there could be a trend reversal. The vice versa is true for a downtrend.
A correctly drawn downtrend
Filters — validity of the trendline breaking
A basic trend change signal is created when either a support or resistance line has been penetrated. The use of Time and/or Price Filters is a common method of trying to avoid false signals:
Time filters
- Some suggest that a close beyond a broken trendline is needed to confirm a break.
- The Two-Day Rule states that the price must close beyond the trendline for two consecutive periods for the break to be considered valid.
Price Filters
A trendline must be broken by a predetermined value or percentage amount (set by the dealer) before the break is considered to be valid. Traders commonly use filters but they are a very personal thing. We suggest experimenting and analysing the market before deciding on your filter. It is possible to employ both Time and Price filters at the same time. Once your rules have been set it is important to maintain the discipline in the heat of the moment and stick to them.
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