The Utility Of Trendlines

Figure 3

Once a technological investor has actually gotten in a placement near the trendline, he or she would certainly maintain the position open till the cost moved below the assistance of the trendline. Numerous traders will suggest over what rates to make use of when developing the trendline, bear in mind that all will certainly agree that the toughness of the trendline increases as even more costs examine the support/resistance. As the rate nears a major support/resistance level, there are 2 various situations that can occur: The price will certainly bounce off the trendline and proceed in the direction of the previous trend, or it will move via the trendline, which can then be utilized as an indication that the existing pattern is weakening or turning around.

Trendline Basics

As stated earlier, trendlines are merely lines that attach a series of rates to provide the investor a far better idea of where the rate of a particular financial investment is headed. As you might recognize, the open, close, high and low rates are easily gotten for most supplies, yet which of these prices should be utilized when developing a trendline?

Figure 3

The Utility Of Trendlines

Once a technological investor has entered a position near the trendline, he or she would maintain the placement open until the price moved below the support of the trendline. Many investors will certainly argue over what prices to use when developing the trendline, remember that all will certainly concur that the toughness of the trendline boosts as more rates evaluate the support/resistance.

Trendlines can vary drastically, depending on the time frame used and the slope of the line. For example, some securities can show aspects of uptrend/downtrends for months, days or even a few minutes, while others can become range-bound and trade within a sideways trend.

Support and Resistance

Trendlines are a relatively simple tool that can be used to gauge the overall direction of a given asset, but, more importantly, they can also be used by traders to help predict areas of support and resistance. This means that trendlines are used to identify the levels on a chart beyond which the price of an asset will have a difficult time moving. This information can be very useful to traders looking for strategic entry levels or can even be used to effectively manage risk, by identifying areas to place stop-loss orders. (For more insight, see Support & Resistance Basics.)

Technical traders pay particularly close attention to an asset when the price approaches a trendline because these areas often play a major role in determining the short-term direction of the asset's price. As the price nears a major support/resistance level, there are two different scenarios that can occur: The price will bounce off the trendline and continue in the direction of the prior trend, or it will move through the trendline, which can then be used as a sign that the current trend is reversing or weakening.

Drawing Your Own Trendlines

As mentioned earlier, trendlines are simply lines that connect a series of prices to give the trader a better idea of where the price of a particular investment is headed. The problem comes with figuring out which prices are used to create the trendline. As you may know, the open, close, low and high prices are easily obtained for most stocks, but which of these prices should be used when creating a trendline?

There is no one, distinct answer to this question. Technical signals generated by the various technical patterns/indicators are very subjective and trendlines are no exception. It is entirely the trader's decision when it comes to choosing what points are used to create the line and no two traders will always agree to use the same points. Some traders will only connect closing prices while others may choose to use a mix of close, open and high prices. Regardless of the prices being connected, it is important to note that the more prices that touch the trendline the stronger and more influential the line is believed to be.

In general, upward sloping trendlines are used to connect prices that act as support, while the given asset is trending upward. This means that upward sloping trendlines are mainly drawn below the price and connect either a series of closes or period lows. Conversely, a downward sloping trendline is generally used to connect a series of closing prices or period highs, that act as resistance while the given asset is trending downward. This is similar to what is shown in the chart above.

We should note that it is possible to use two trendlines on the same chart. However, this method, known as a channel, goes beyond the scope of this article.

(To learn more about this technique see, Channeling: Charting A Path To Success.)

To illustrate the concept of drawing an ascending trendline, we have chosen to look at the trading action of AutoDesk Inc. (ADSK) between August 2004 and December 2005. As you can see in Figure 2, the trendline is drawn so that it connects the lows illustrated by the black arrows. Once a trendline is established, traders would expect to see the price of the asset to continue to climb until the price closes below the newly formed support.

The Utility Of Trendlines

Figure 2

As time goes on, we can see in Figure 3, that the price tested the support of the trendline again in August 2005. This is important because the more times the price touches the trendline, the more influential the line is said to be. The price action illustrated by the arrow on the far right would be used by traders as confirmation that the trendline is valid. In this case, traders would look to enter a long position as close to the trendline as possible.

The Utility Of Trendlines

Figure 3

Once a technical trader has entered a position near the trendline, he or she would keep the position open until the price moved below the support of the trendline. Most traders will constantly adjust their stop-loss orders by moving them higher, as the trendline continues to slope upward. This method ensures that a trader can lock in as much of the gain as possible, without being taken out of the position too early. Keeping a stop-loss order below an influential trendline is a strategic way to ensure that the asset has adequate room to fluctuate, without getting whipsawed. In this case, using the ascending trendline as a guide of an expected move higher would result in a very profitable trade, as you can see in Figure 4.

The Utility Of Trendlines

Figure 4

The Bottom Line

Trendlines are used commonly by traders who seek to ensure that the underlying trend of an asset is working in favor of their position. Trendlines can be used effectively by traders to gauge potential areas of support/resistance, which can help to determine the likelihood that the trend will continue. This strategic advantage is available to any trader willing to take the time to learn how to draw a basic trendline and incorporate it into his or her trading strategy. Although many traders will argue over what prices to use when creating the trendline, remember that all will agree that the strength of the trendline increases as more prices test the support/resistance.

(To learn more about chart patterns, check out the Technical Analysis tutorial.)

Tip: For investors’ reference only, it does not constitute investment advice. Financial investment products have high risks and are not suitable for every investor. If necessary, please consult a professional consultant.