Trend Lines - They May Look Simple But Think Again

Most traders make a hash out of drawing trend lines

I talk about this subject quite a bit. Many traders think I'm nuts. After all, trend lines are the most simple of all analysis techniques aren't they? You don't need training to draw a trend line.

Well, if that was the case then you wouldn't see so many technical analysts making a complete pig's ear of them.

This is the sort of chart I am used to seeing:

Most traders seem to work on a hit and miss basis, drawing as many lines as they can and hoping that one of them will work. The mistake they generally make is that they don't actually draw trend lines. They only draw lines and on that basis, since they are not drawn on a trend, they will fail.

There is no benefit from drawing lines without any logic to them. When they are drawn correctly they provide significant benefit and often great trading opportunities. However, these occur very infrequently.

So how should a trend line be drawn?

First of all, before providing examples, let's just consider the word "trend". Just what is a trend? Well, by definition a trend is a sustained move in one direction and is accompanied by a very simple concept:

• Up Trend = A series of higher highs and higher lows
• Down Trend = A series of lower lows and lower highs

Note that in an uptrend both lows and highs move higher. It is common but not a rigid rule for a support line to be drawn across the rising lows.

Note that in a down trend both lows and highs move lower. It is common but not a rigid rule for a resistance line to be drawn across the declining highs.

Now look back at the first chart and see how many times the lines were drawn on trends... Perhaps once it occurred.

When drawn correctly this is what will happen...

You can see how in this chart of USDJPY how both highs and lows were declining and once price reversed back above the line we saw a sustained reversal.

However, in many cases the break of the trend line will occur followed by a retest of the trend line. The retest will provide an excellent opportunity to establish a position on that test.

The other tip is not to necessarily draw trend lines from the lowest low or the highest high on the chart. Quite often the lines that provide the best signals can be drawn across what I term an "intermediate trend." What I mean by this is that quite often a trend will occur within a particular wave pattern. Without getting too deep into the topic of Elliott Wave, consider an entire trend will come from the 5-wave sequence of 1, 2, 3, 4, 5 and possibly the trend can be drawn on Wave 5 only. This can be the provider of the final retest on which you can establish a position.

An example of this is shown in the chart here.

First most traders will draw the line in red. Invariably this will rarely provide any profitable signal so only draw these lines once you have been able to identify the line having touched price a minimum of three times.

Note that price declined in three sections which I have labeled (a), (b) and (c). Across the declining peaks in the move lower in (c) I have drawn a resistance line which has touched price three times (the minimum I will accept before I consider the trend line as valid.)

Note how price has subsequently broken above the trend resistance line and after the first move higher it reversed to retest the trend line which provided an excellent buying opportunity.

When a trend line is broken the retest is quite common and is a useful feature of a trend line that has been drawn correctly. By breaking above the last peak in the decline (at touch number 3) we can confirm that the trend in (c) is complete and should then trigger a deeper pullback.

By adhering to these guidelines the results you get from you trend lines will be much more profitable and you will be able to have more confidence that the line has a greater chance of providing a solid signal.

However, I should add that in my daily analysis across several currency pairs I often have no valid trend lines drawn. In reality they occur very infrequently but are more productive when applied accurately.

A Simple Tool to Help in Identifying Trend Reversal

There is a great deal of nonsense written about trends and using trend lines. Quite often - and maybe even the majority of the time trend lines aren't even drawn on a trending move and traders then cry when they lose money because of a trade they had based on the break of their line.

To be honest the concept of a trend is really one of the most simple tools in a trader's toolbox but the definition of a trend is normally forgotten and could actually help your trading considerably. Let us just cover the definition of a trend:

• Up trend A sequence of higher highs and higher lows
• Down trend A sequence of lower highs and lower lows

It really couldn't be much simpler than that.

Sometimes - and in spite of the number of lines that traders draw - this doesn't happen very often, a supporting line can be drawn across the lows in an up trend or above the highs in a down trend.

In most cases you can consider trading a break of the trend line. At this point you do have to be a little careful since if the previous low in an up trend (previous high in a down trend) is not exceeded there is still chance that price can go and retest the trend line and occasionally this can be at a new extreme.

You can see in this example how even though the trend line was broken the prior low in the sequence of higher lows was not penetrated. Following this price rallied to retest the trend line twice, the second time at a new high before it finally broke lower. You would normally expect momentum indicators to be showing a divergence at this point.

How can this be used in a practical way?

Well recently in Pro Commentary I had identified a peak in EURUSD that stalled at 1.2902 and I forecast a retracement to below 1.2800 with a favored target at 1.2745. In fact it only moved down to 1.2761. At these times when it is uncertain whether the correction is complete or whether price will move lower to target it is possible to consider the concept of a trend. Here is the 2-hour chart:

Following the break of the sequence of lower highs I confirmed to readers that they should expect to see the up trend resume with support between 1.2790-1.2805 holding and would eventually reach the 1.2976 high and probably later to 1.3180.

While identifying targets of where to find support or resistance requires knowledge of how price develops and the relationships in those moves followed by what sort of correction to expect, the concept of when the correction is complete is actually quite a simple process.

You can use this very simple tool with great effect.

Using Average Directional Index - A useful addition to your toolbox

Many traders concentrate on the popular momentum indicators looking for overbought and oversold signals and possibly even price/momentum divergence at the end of a trending move.

Let us just look at how Rapid RSI performs in identifying overbought and oversold signals in the daily chart for the US Dollar vs Japanese Yen:

Very clearly it has been very successful and if this is your first experience of using momentum indicators you may start imagining buying your first yacht! However, as with just about any technique in technical analysis it is never quite that simple. Let us take a look at a different section of price action:

Quite clearly while the first two signals (first a sell signal followed by a buy) were very successful.

However, following this Rapid RSI issued constant sell signals but price continued directly higher.

What has happened?

Very simply, momentum indicators will provide good overbought/oversold indications within a consolidating and freely swinging market. However, this breaks down when the market begins to trend - and this is what happens in USDJPY.

During a trend momentum indicators will spend most of the time oscillating around the overbought or oversold extreme and will never provide a signal in the direction of the trend. At these times we need to ignore momentum signals. What we need to try and organize is a method of recognizing when price begins to trend. This can be managed by using another Welles Wilder indicator, Average Directional Index - or ADX.

Let us apply this on the same chart.

On this chart I have added in ADX (in green) along with +DI and -DI in blue and red respectively.

+DI and -DI display the individual positive and negative movement seen and when price direction is higher it can be seen that the +DI line crosses above the -DI line and vice versa.

ADX is the Average Directional Movement of both positive and negative moves. It can be seen that when price moves consistently in one direction (ie there is a trend - this may be an uptrend or downtrend) ADX rises above the 30 line to indicate that a trend is under development.

I have marked on the chart when this occurs approximately. Then, while ADX is rising above 30 it is possible to ignore the RSI signals.

However, ADX is a lagging indicator by definition and there will always be a period before it moves above the 25-30 area when the momentum indicator moves into the overbought or oversold area. How can we manage that situation?

Well first of all, just because the momentum indicator has moved into the extreme area, it is not an automatic trading opportunity. In this case, when Rapid RSI moves into overbought territory we should be examining price action in not only the daily chart as shown, but also the intraday market.

In this case I have taken the lead-up to the point until ADX crosses above the 25-30 area. What is very evident is that it is following the very basis of a trend - that is swing highs and moving higher as well as swing lows moving higher.

The picture above shows an uptrend where both peaks and troughs are rising and when one of the troughs is broken then we are on warning that a reversal in trend is possible.

In the case of the USDJPY daily chart it is quite clear from the inset that we never saw break of one trough and therefore we should be staying with the move higher even though ADX hasn't yet registered this mathematically as a trend.

We have been able to draw a supporting trend line across several troughs and when this breaks we can say that the trend is probably complete. There is a small risk of moving back to retest the trend line after breach and this does occasionally occur at new high, but given that ADX has already begun to decline we can more safely assume the uptrend is complete and can look for Rapid RSI to provide overbought and oversold signals.

So look to add ADX into the list of indicators you use to provide an objective view of when a trend is in place. It is a good addition to your tool box, adding information instead of duplicating with yet another momentum indicator.

At less obvious time you can refer to Pro Commentary for information on projected targets and yet another objective view on the market.