Trend lines are one of the most basic concepts in day trading, and easily argued to be one of the most powerful concepts.
Trend lines have been used for trading as long as there have been markets.
From stocks, currency, commodity, futures, and now even bitcoin, trend lines tell the complete story of the stock.
Trend lines are based upon a simple idea that markets move in both up and down trends.
Therefore, a trend line shows a trader 3 key factors:
- The general direction current price is moving (upwards, downwards, sideways)
- Strength of the current price movement
- Future support and resistance zones
Now, if this sounds fuzzy… don’t worry… because I’m going to cover this extensively for you. In fact, I’m going to show you the three key factors when trading off trend lines.
You should already know that Support and Resistance Lines (S&R lines) are horizontal areas on your chart that shows potential buying and selling pressure.
Support and resistance are nothing more than horizontal “trend lines” at the end of the day.
Did you know that they are also one of the oldest and most successful trading set-ups a trader could use reaching back to the 1800’s?
There is a reason that traders use this tried-and-true method for making money.
Pro tip: Skip the fad ideas and stick to what works.
Trend Lines work the same way as S&R Lines but instead are sloping to support the price.
Here is a trend line example compared to horizontal S&R lines.
Defining a trend line:
Upward trend lines: Sloping area on the chart that shows upward buying pressure.
Downward trend lines: Sloping area on the chart that shows downward buying pressure.
Now let’s not start drawing sloping lines all over. There is definitely a correct and incorrect way to do this.
This is what NOT to do…
This is obviously exaggerated for an example but I have to say I have seen traders charts looking like this far too frequently.
For some reason people believe they look “sophisticated” by drawing as many trend lines on their charts as possible.
Let’s continue and find out how to draw them the right way.
How to Draw Trend Lines correctly
You don’t want to draw trend lines like that above.
It is clearly garbage…
It’s garbage because you would never know which trendline is important.
How would you know which one to trade or which to ignore?
Trend lines drawn like this will most likely leave yourself confused about which way the market is trading.
Pro tip: It’s always best to draw as few trend lines as possible on your chart.
Here is how to draw a trend line correctly:
- Focus on major swing points only. Ignore all minor swing points.
- Connect at LEAST 2 major swing points to define a trend.
- Adjust to get the most number of touches of trend line.
Here is an example of a Trend Line that meets all 3 of the above criteria:
Pro Tip: Unlike horizontal S&R Lines, Trend Lines needs to be constantly “adjusted”
Why do Trend Lines need to be adjusted?
To update the support and resistance of the trend.
Essentially you need to maintain an up-to-date trend.
When a trend line is broken or the markets move in a different direction away from a trend line, you then need to adjust the trend line to fit the recent price action.
Using Trend Lines to identify market conditions
Once you have identified where a trend line goes, you should ask yourself…
“What is the next step the market is looking to take?”
What I mean is, does the overall market “feel” like it can go higher or lower?
This example chart is in a clear down trend.
As you can tell, price recently came up to the trend line resistance and immediately encountered selling pressure at that price level.
This is indicating that the market conditions are currently not changing and the market wants to continue in its downward pattern.
But that’s not all.
The “steeper” the line usually indicates more momentum or strength behind the market trend.
This could be a strong indicator for the likelihood of price continuing in the direction of the trend.
Remember: If a “steeper” trendline is broken, it is usually followed up by higher than usual price movement.
Make sure to remember that this break signaled to the bulls that the bears are now in control and it’s time to exit their trades.
Remember – don’t get complacent!
Just because the price was rejected now does not mean it will be rejected again in the future.
This type of thinking is a recipe for disaster!
Trend line breaks are some of the easiest ways to get caught in a trade with serious losses. This is due to the momentum that is built up in that price action near then trend line.
Two ways to trade a Trend Line
There are two ways a trader can take advantage of a Trend Line.
They can either:
- Trade in the direction of the trend(continuation)
- Trade against the trend(reversal)
There are many things a trader can do to “convince” themselves of an outcome they want to happen while trading.
It’s best to remember that at any time that a trend line is not a guarantee and should be traded with caution.
Many times traders find themselves “caught” on the wrong side of the trade by incorrectly identifying whether the trend is going to continue or the trend is going to change directions.
Let’s take a look at each way a trader can utilize Trend Lines
1) Trade in the direction of the trend
For trend following traders, Trend Lines can provide some excellent entry levels with insanely high reward-risk ratios.
I’m talking 10:1 or more for your returns.
Most traders are happy with 2:1 or 3:1 risk to return.
Talk about a great opportunity to get involved trend with those types risk to reward numbers.
Let’s take a look at the SPY chart and see how following the strong uptrend worked.
Let’s break down the above example trade.
- There are 3 major pivots identified
- The major trend was signaling higher prices
- Price signaled future support was likely to hold this trend
Once the trade was initiated at entry price 1 we then got 2-3 additional entry prices to continue the trade.
2) Trade against the trend
This one is a little bit more tricky to master.
Newton’s first law of motion describes something called inertia and how it applies to objects.
According to this law…
“A body at rest tends to stay at rest, and a body in motion tends to stay in motion, unless acted on by a net external force.”
– Newton’s First Law of Motion
And the same applies to trading.
A stock in a trend tends to stay in a trend, unless a strong countertrend force acts on it.
Meaning that it takes significantly more force to reverse a trend then it does to maintain a trend.
Let’s take a look at a recent SPY trend that failed to hold its trend line.
As you can tell, there was more significant forces acting on the stock and caused an explosive failure.
Pro Tip: It’s typical to see explosive failures like this, so keep tighter stops just under trend lines to maintain appropriate risk levels.
Using additional indicators to give you better entries
There is a reason for the saying, “power in numbers”, and the same is true in trading.
What I mean is…
The more supporting indicators you have suggesting a long or a short, the better or stronger the signal is going to be.
For example, let’s take a look at an example trade with multiple entry signals all at the same price.
Powerful, isn’t it?
There are a lot of different ways to view the stock market.
Like everything else, this is only one additional piece of information that should help to identify what the markets are going to be doing.
- When you draw a Trend Line,
- Focus on major swing points
- Connect major swing points
- Adjust the line to get as many touches as possible
- The steepness gives you clues about the market condition
- Trading with the trend gives you the best risk-to-reward ratios
- If a trend line breaks in the opposite direction, the movement can be explosive
An Added Bonus
Did you know that trend lines can be drawn on indicators as well?
Use trend lines on RSI, CCI, MACD, or any other indicator, and they show the same information to the trader but on the indicator values instead of stock price.