The Trend Line – A powerful weapon in a trader’s arsenal
There are so many indicators available to traders and investors today that some of the most simple and effective ones are sometimes overlooked. Trend lines can be a trader’s best friend because they are so versatile, easy to use, and most importantly, proven.
What is a trend line?
A trend line can define an up or down trend
A diagonal trend line is formed by connecting two or more points along a chart. If we can establish a trend, we can determine where the market wants to go. Wikipedia defines “market trend” as a prolonged period of time when prices in a financial market are rising or falling faster than their historical average. Irrespective of speed, we are concerned with establishing a trend. Most of the money of any trading strategy is made inside the trend, meaning that a trader should stay within the trend to maximize profits.
In the weekly price chart above, we are looking at an upward sloping trend line (“up trend line”), highlighting a very bullish trend that occurred in oil futures back in 2007-2008. In this up trend line, oil was making higher lows as well as higher highs. In looking at this trend, we note that there are no less than five specific points anchoring the trend line. This is important because the more points that define the line, the more valid the trend becomes. Unfortunately, the more price points there are to validate the trend, the higher the likelihood of the trend breaking down. Traders need to be aware of a maturing trend, where you are likely to encounter tests and potential break-downs in the trend.
You will also note that we have drawn the up trend line along the lowest points on the price bars. The first two anchor points of the trend line form what we call the “target trajectory”, and we simply let the ensuing lows of each subsequent price bar lay down onto the line. This is why you see the line being pierced momentarily in August of 2007.
A trend line can define areas of support and resistance
In the next graph, we are looking at the same chart, except that we have drawn two additional horizontal lines to indicate a period of congestion that occurred between November of 2007 and March of 2008.
As you can see, by drawing a horizontal trend line to the right of the high of November 5th, we get an indication of where future resistance might be. However, it is not yet valid since we have only one data point. However, as oil plummets, then reverses course and retraces back to the $98 level, we now have a valid trend line and confirmed resistance. Similarly, as a result of the sell-off that occurred on November 12th, we have a provisional horizontal trend line, highlighted by the dashed line. Since we only retrace back to around $85 on December 3rd, we now have valid support as indicated by the solid line and a secondary support line, indicated by the dashed line. As can be seen, the market tested and failed at the $98 level on December 31st. The market also held at the $85 support on January 21st and February 4th. The support level in February also illustrates a powerful feature of multiple trend line crosses. When two or more lines cross, it increases the likelihood of either resistance or support holding at these points.
A trend line can define retracement levels from breakouts of major areas of support or resistance
By looking at the same chart, we note that once oil prices broke out from resistance at $98, they hit $110 very quickly before retracing back to the $98 level that now had become support. This is an important point to make with regard to trend lines. That is, once a trend line is effectively pierced, it becomes support/ resistance and vice versa. Oil prices held at the $98 trend line level a few weeks before heading higher.
As we also see at the $110 level trend line, this level was tested only once before moving higher. However, resistance became support and on April 28th, the price of oil tested that same level and held before moving higher.
Using the trend line in order to confirm a change in the prevailing trend
As was the case with support/resistance levels, breaks in up/down trend lines, signify important turning points and should be taken seriously. In the graph below, we show the previous trend lines, together with a new down trend line that is maintained from the top in the middle of 2008 to the bottom in February of 2009.
Whereas the up trend line uses the lows of two or more price bars, the down trend line is formed by connecting the highs of two or more price bars. As can be seen from the price graph, the July and August 2008 highs form the target trajectory of the down trend line. It is interesting to see the price of oil touch previous trend line support of approx. $110 in August of 2008 before touching and breaking major trend line support at $105 in September. Note that there is a retracement back to the up trend line in late September at a major trend line cross, indicating that the trend line resistance at $110 will hold. As the price of oil closes below the up trend line in late September after having touched a major resistance trend line cross, the price of oil breaks down and moves lower precipitously.
Using trend lines to create trading channels
In the following graph, a weekly price chart for the 5-year Treasury note futures contract is depicted. As can be seen, there are several trend lines drawn in.
We focus first on the April 2010 low of around $113, which is our first data point. At this point, we cannot assume a higher trend until the second data point of approx. $115 is revealed in late February of 2011. We now draw the major trend line out and simultaneously copy the major trend line to the high of $122. This provides us with potential major resistance levels moving forward. As we observe, in August of 2011, 5-year Treasury futures hit the major resistance level indicated by the trend line before reversing.
However, prices bottomed in October of 2011 around a low of$121 before heading higher. This becomes our first data point for a minor support trend line. In January of 2012, prices hit a high of $124 before heading lower. We now have a minor resistance trend line, depicted by the dashed line. Prices move back to a low of $121 in March of 2012, which becomes our second data point for our minor support trend line. We copy the line up to the first minor/major trend line cross to reveal a target trajectory for minor resistance. As can be observed, prices hit the minor resistance trend line no less than five times after this. There was also a break down on minor support at around $122 in May of 2013, which subsequently led to deterioration in bonds. Major trend line support was pierced in June of 2013 and predictably, prices moved back to the area of major support that now had become resistance.
Conclusion: Trend Lines
Trend lines should be actively used as part of any trading strategy, whether you are a technical trader or otherwise as these lines give you great insight into the direction of the market and major resistance and support. As with most technical tools, it takes time to become familiar with how to use trend lines effectively. A good practice to follow is to use other indicators in conjunction with trend lines in order to confirm whether a price move is valid or not.