This article will discuss the construction of trendlines, use of trendline in support and resistance analysis, and extended trendlines.
USE OF TRENDLINE IN SUPPORT AND RESISTANCE ANALYSIS
Having learnt how to draw trendlines, we will now show why they are so important in technical analysis. Trendlines not only show the direction of the trend, but also importantly they indicate what the levels of support and resistance are. An uptrend line that is drawn by connecting the lows supports the price movement and during an uptrend, we expect the price to be moving above the uptrend line. On the other hand, a downtrend line that is drawn by connecting the tops provides resistance to the upward movement of the price and here we expect prices to move below the downtrend line.
Any breaking of either the uptrend and downtrend line indicates a possible change in trend, thereby warning the trader to adjust its position accordingly.
With the above understanding of the support and resistance provided by the trendlines, a simple strategy can be devised by buying near the uptrend line and selling or shorting near the downtrend line. This increases the odds of a successful trade because a strong support or resistance level requires more effort by the sellers to break in the former and buyers to break in the latter.
Hence, we expect those levels to hold more often than not. A second strategy centres on cases where trendlines are broken successfully, which signals a possible and likely change in the sentiment or price momentum. When an important uptrend line is broken, the trader may decide to sell part or all of his holdings or take a short position.
Similarly, the bullish signal generated by the breaking of a downtrend line may invite a long position to be taken.
While the above strategies are simple, their effectiveness relies very much on identifying strong and dominant trendlines. On any given chart, multiple trendlines can be drawn. A simple rule of thumb to identify the most important ones is the line that have the most contact points (line touching most number of lows or tops) and that extend over a longer timeframe. Those important trendlines provide very good indication whether a trade has a good risk-reward ratio. Figure 2 shows how trendlines provide support and resistance to the price movement. Notice how the breaking of the important trendlines indicates a turnaround in the market sentiment.
EXTENDED TRENDLINES
When trendlines are broken, such lines should not be discarded as they retain much importance in future price movement. Extending a broken trendline to determine future levels of support and resistance is termed extended trendlines.
Figure 3 shows such an example of extended trendline. With the two lows in October and December 2005, an uptrend line was drawn. Having been tested numerous times during the period May to October 2006 with the sellers unable to break the uptrend line, this line has become an important and major trendline. When it was finally broken in November 2006, we extended the trendline with the extended trendline briefly resisting upward price movement (shown by the red arrows). When the prices again went above the extended trendline, the line is once more providing support to the price movement.
This chart of Tat Hong illustrates why it is important to extend a major trendline with the line initially providing support to the price movement, then resistance and then support again. Hence, if prices of Tat Hong were to drop to the extended trendline in future, we can expect very strong support to be provided by this extended trendline.
The use of trendline is a very important component to build a successful trading strategy. While some traders use trendlines alone to trade the market, it is advisable to combine the use of trendline with other facets of technical analysis such as price and volume indicators to determine the price momentum and money flow when prices are near the trendlines or when a trendline break occurs.
Charting softwares such as ChartNexus have drawing tools that let you easily draw trendlines and add annotations to the charts.
