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Saturday, December 15, 2007

Trends and Trend Lines

Trends and Trend Lines
Trend lines seem to be the forgotten trading indicator. Many traders under estimate the importance of using trend lines to predict significant price moves and reversals. Many traders also do not know how to correctly draw trend lines.

We draw trend lines
to determine a specific trend, its strength and try to establish potential reversals. The old adage "the trend is your friend" is all to often only remembered once the horse has bolted and we have been stopped out at a loss doing a counter trend trade.

The market can only go three ways up! down! or sideways.

Now that we have established that the market can only go up down or sideways. Let’s investigate a trend and what causes the market to trend in a particular direction.

The Market is in an uptrend when it is making higher highs and higher lows. Look at the typical up trend chart. You will notice the market is making higher highs and higher Lows. Like walking up a flight of steps. What constitutes a high in the market? (see support and resistance) The rule of thumb is when the high candle has 2 lower candles on its left and 2 lower candles on its right.


The Market is in a downtrend when it is making lower highs and lower lows. Look at the typical downtrend chart. You will notice the market is making lower highs and lower lows. Like walking down a flight of steps. What constitutes a low in the market? The rule of thumb is when the low candle has 2 higher candles on its left and 2 higher candles on its right.


Sideways movement is when the market runs out of steam and consolidates at a particular point before continuing with the trend or moving in the opposite direction. We need to identify periods of consolidation and avoid trading them if the range is very small. Rather position yourself to take advantage of the breakout when it occurs.

Volume is what makes the price move. The higher the volume of buyer’s or seller’s at a particular moment the more the price will move in that direction. Some of factors that cause volumes to change are technical traders that open or close trades because their perception is the chart pattern indicates such action is warranted. Fundamental traders watch the news, read the papers and listen to analysts predictions, forming an opinion as to the future price movement of a particular market. The more traders who share a particular perception or opinion the larger the change in volume is likely to be.

It is these changing opinions of traders that cause the prices in the market to fluctuate. As these prices fluctuate new support and resistance levels are tested all the time until enough like minded traders share the same opinion and cause the market to move in a new direction.

Once price has moved sufficiently in a particular direction we call this a trend. The aim is to identify the trend as soon as possible and enter the trade in the direction of the trend. Volumes will probably peak by the halfway mark and continue to reduce, causing the trend to slow and lose its momentum resulting in the trend coming to an end. Quite frequently volumes will increase right at the end of the trend.

The trend comes to an end when traders start to take profits, others close on stop losses because they can no longer sustain losses, still others only then realise that the market was trending in a direction and enter right at the end of the trend. Some traders will be opening positions in the opposite direction assuming the trend had come to an end. All this leads to an increase in volume and then consolidation before the market continues in the same direction or reverses.

Look at the volume bars at the bottom of the above Chart. Volumes peaked on the long down candle on the EUR/USD Then tapered off to a trickle. The market went sideways or consolidated then volumes suddenly increased pushing the market back up before consolidating again when volumes decreased again. When price broke through the support volumes again increased causing the market to retrace further down.

Placing Trend lines.

Trend-lines can be placed in 3 different categories. Current trend lines, Outer trend lines and long term trend lines. We have already learnt that an Up Trend is a market that is making higher highs and higher lows in the market. The question then is, where do we put our trend Lines? In an up trend we draw a line through the lows of support in the market.

The above 4 hr EURUSD chart shows the 3 trend lines. The sustained 4 month uptrend never once broke the long term trend line during the 4 months. When it finally broke through it found brief support at the outer trend line.

Once it broke through that support it found further support on the long term trend line. Twice it tested the outer trend line support before rallying back up the the back of the outer trend line to meet resistance there

Price then retraced back through the long term trend line only to rally again and meet further resistance on the back of the long term trend line. When it failed to rally above the back of the long term resistance it retraced further down.

You will also notice with each new break out volumes increased. As with normal support and resistance trend lines that were once support became resistance. These trend lines not only confirmed that the uptrend was intact for 4 months it also gave us an early warning of the trend reversal

These trend lines were plotted on the 4 hour charts but we need to remember that they work in all time frames. Generally the larger the time frame the stronger the trend line. We also look for at least 2 touches on a trend line to make it technically a valid trend line. The more touches on a trend line the more impenetrable that trend line is thought to be

Remember also that there are trends inside of trends. This is because the market does not go in a straight line. It is forever moving up and down, but slowly making its way in one direction or the other. When a current trend line is broken, the market can move down to the outer trend line before continuing on its way up again. Or it might break through the outer Trend line and continue to the long term trend line.

To find your current Trend Line go back to your last 2 levels of support and draw your upper trend line through those highs and lows

To draw your outer trend Line draw your line across all your lows or support levels on the chart starting at the left and extend it up and forward.

The 2 breaks of the current uptrend line would have amounted to almost 500 pips on the EURUSD regardless of any other indicators used.

To find your long term trend line change to a higher time frame like the 4hr or daily chart. Also remember that your trend line is dynamic by nature and has to be changed as the market changes.

How do these Trend Lines Help us to Trade?

On the above 1hr EURUSD chart I have plotted numerous current trend lines each resulting in good trades. With trend lines we can place forward orders in the market so that even if we are not there the trade will be executed. You will also notice that with each trend line break there is generally an increase in volumes. Many of the trend line breaks occurred near the high or low in the market allowing us to enter the market at the earliest possible opportunity to maximise our profits.

We can also use trend lines
to set stop loss levels as well as take profit levels. The above chart clearly illustrates the importance of following the trend in the market and using trend lines to give you entry and exit points. Remember the down trend is just the opposite of the up Trend and the same rules apply. Trend lines are probably the most common form of technical analysis used today. They are probably one of the most under utilized as well. If drawn correctly, they can be as accurate as any other method.

As with support and resistance we can wait for a breakout candle to open clear of the trend line. Once we have the breakout candle we can wait for the confirmation candle to open or close above or below the breakout candle before entering the trade. (see next chart)


If we take trend lines a step further and draw a parallel line at the same angle of the uptrend or downtrend, we will have created a channel. To create an up (ascending) channel, simply draw a parallel line at the same angle as an uptrend line and then move that line to position where it touches the most recent peak. This should be done at the same time you create the trend line.

To create a down (descending) channel, simply draw a parallel line at the same angle as the downtrend line and then move that line to a position where it touches the most recent valley. This should be done at the same time you created the trend line. When prices hit the bottom trend line this may be used as a buying area. When prices hit the upper trend line this may be used as a selling area.

The channel lines not only serve as entry points but also exit points or profit targets and stop losses.

Channel Breakouts
The channel lines are also useful for identifying breakouts either long when it breaks through the upper channel or short when it breaks through the lower channel. The obvious profit targets for these trades being the previous highs or lows above or below the channels.

As we can see from the above EUR/USD 1 hour chart the market was in a down channel then broke out long. The breakout of the channel was an ideal opportunity to enter the market long and make almost 200 pips on the trade. A new up channel formed and almost went back to to previous high in the market.

  • Place your trend lines on your charts every day. (They can alert you early of an impending reversal.)

  • Trade with the trend. Use your trend lines to determine the various trends and rather trade with the trend. Don't try to guess tops and bottoms for reversals.

  • Draw in your channel lines. Channel line not only give you a clear picture of the current trend, they also provide you with entry points, profit points and stop loss levels.

  • Used in conjunction with other indicators they are very powerful tools.

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