Trendlines vs. Support and Resist
The basis of technical analysis is the assumption that prices trend and the use of trend lines is vital for both identification and confirmation of the trend. A trend line refers to a straight line that connects multiple price points and then extends into the future for acting as a support or resistance line. There are many principles that you can apply for support and resistance levels, as well as trend lines.
Uptrend line: An uptrend line forms by connecting multiple low points with a positive slope. The first low must be lower than the first if you want a positive slope for the line. Also, keep in mind that you need to connect at least three points to consider the line a valid trend line.
Downtrend line: Opposite of the uptrend line, a downtrend line forms by connecting multiple high points, and has a negative slope. The first high must be higher than the second to have a negative slope. Again, remember that you have to connect at least three points to consider it a valid trend line.
How to Build a Trendline?
The trendline is one of the essential tools that technical analysts use. Instead of checking past business performance or any other fundamental, technical analysts check for trends in price action. Trendlines help technical analysts in determining the current direction in market prices. Technical analysts believe that identifying the trend is the first thing to do for making a good trade.
You can draw trading channels on charts to see uptrends and downtrends in a forex pair, commodity, ETF, or stock. Traders also identify potential buy and sell points and set stop-loss points and price targets by using channels. During uptrends, ascending channels angle up while during downtrends, descending channels slope downward. Other technical indicators, like volume, also enhance signals from trading channels. The duration of the channel helps to determine the underlying strength of the trend.
When it comes to technical analysis, a channel appears when the price of an asset moves between 2 parallel trend lines. While the upper trendline generally connects swing highs in price, the lower trendline connects lows. When the price is breaking out of a trading channel upwards, the move may be indicating that the price will rally further. For instance, you can see a channel and breakout for Hyatt Hotels Corporation stock in the chart below. On the contrary, when the price breaks below the channel, the dip indicates the possibility of more selling on the way.
The trading channel technique usually is best for stocks, with an average amount of volatility. It is crucial to determine the amount of profit you can possibly earn from a trade. For example, the channel will not be massive, with low volatility. It means smaller potential profits. Bigger channels usually associate with more volatility, which means larger potential profits.
How to Trade Using Trendlines?
An analyst should have a minimum of two points on a price chart to create a trendline. Some analysts prefer using varied time frames like five minutes or one minute. Others go for weekly charts or daily charts. Some depend on tick intervals to view trends rather than time intervals. The reason trendlines are so global is that analysts can use and apply them to identify trends, regardless of the time frame, period, or interval they use.
For example, if company A trades at $35 and goes to $40 within two days and $45 within three days, the analysts have to plot three points on the chart. He/she also needs to start at $35 and then move to $40 and $45 one by one. Where there is a line between the price points, it becomes an up trend. This trendline has a positive slope. Hence, it tells the analyst to buy in the trend direction. However, If the price of company A changes from $35 to $25, it indicates a negative slope of the trendline, which means that the analyst must sell in the direction of the trend.
It is relatively easy to use trendlines. Traders simply need to chart the price data, usually by using high, low, open, and close. Look at the candlestick chart with the data for the Russell 2000. Here, the trendline applies to three-season lows over two months.
Here, the trendline indicates the uptrend in the Russel 2000. When you enter a position, you can think of this trendline as support. In this case, traders can enter a long position near the trendline before extending it into the future. If the price action on the downside breaches the trendline, the traders close the position by using it as a signal. So, when the trend you are following begins to weaken, you can exit.
Trendlines offer great insight, but if you misuse it, you can also get false signals. Traders can employ other items like horizontal support or resistance levels and peak-and-through analysis for validating trend line breaks. Trend lines are a prevalent part of technical analysis, but you need to keep in mind that they are merely one tool to analyze, confirm, and establish a trend. So, you should not consider trendline breaks as the final arbiter. You can only use them as a warning for an imminent change in the direction. By doing this, traders and investors can pay more attention to other signals confirming potential changes in trend.