Sometimes it feels like computers can make things more complicated than they really need to be. One case in point is technical analysis. With affordable computers available to the masses, it seems like the battle between software makers is to see who can pack the most features into their programs. However, sometimes the most simple of analysis techniques can be just as useful as the most complex indicators.
Trendlines are one of hallmarks of technical analysis. This makes sense, given that technical analysis is built on the premise that prices trend. Well-known technician John Murphy wrote this about trendlines in his book “The Visual Investor”: “The simple trendline is possibly the most useful tool in the study of market trends. And you’ll be happy to know that they’re extremely easy to draw.”
In this installment of Technically Speaking, we discuss the basics of trendlines and how you can use them in your investing.
A trendline is a straight line that connects two or more price points. Extending this line into the future, it also acts as a line of support or resistance. There are two types of trendlines—the up trend and the down trend.
An up trendline has a positive slope, meaning it rises as you move from left to right on the chart. An oft-used definition of an up trend is higher highs and higher lows. Typically, up trendlines are formed by connecting two or more low points on a chart. The key is that the second low must be higher then the first in order for the line to have a positive slope. Figure 1 illustrates an up trend.
Extending the up trendline into the future provides a good indication of future support levels. As long as the trend is up, demand is outstripping supply even as the price rises. Increasing demand in the face of rising prices is a bullish sign and as long as prices remain above the trendline, the up trend is considered intact.
Eventually, there will be a break below the up trendline. This occurs when supply begins to outweigh demand. Breaks below the up trendline indicate a change in trend could be coming. Once the up trendline is broken, chances are it may become a level of resistance that stifles further upward price movement.
A down trendline has a negative or downward slope that is formed by connecting two or more high points. The second high must be lower than the first in order for the line to have a negative slope (lower lows and lower highs). Figure 2 shows a down trend.
Extending the line forward provides an estimate of future resistance levels. During down trends, supply is increasing relative to demand even as prices fall. A declining price with increasing supply is a bearish signal; the down trend remains intact as long as prices remain below the down trendline.
A break occurs in the down trendline when prices move above it, indicating that supply begins to wane relative to demand. Such breaks above the down trendline may indicate that a change in trend is imminent. However, it is a good idea to wait until the price establishes higher bottoms before drawing a new up trendline.
As we said, it takes two or more points to draw a trendline—up trend or down trend. However, when looking to draw trendlines, the temptation is to merely draw them through extreme high and low points. It is better to draw a trendline through points where the price has momentarily pulled back and reversed direction. The more times prices “touch” the trendline, the more “valid” the line becomes as a level of support or resistance. Without two points, you cannot draw a trendline. Therefore, it is not always possible to create a trendline.
The spacing of the lows used to form an up trendline and the highs used to form a down trendline should not be too far apart, or too close together. The “proper” distance between points will largely depend on the timeframe used with the chart, as with all price movement. Ideally, trendlines are made up of relatively evenly spaced lows or highs.
The steeper the trendline, the less valid the support or resistance level it represents. Steep trendlines are caused by sharp advances or declines over a short time period. Prices that are moving upward or downward rapidly cannot be sustained in a trend; eventually prices will move below or above the trendline.
There may be times when you are drawing a trendline that the highs and lows will not match up exactly, perhaps because the angle of the trendline is too steep or the points are too close together. In these cases, you may be able to draw “internal” trendlines that ignore one or two points. However, you should ignore points sparingly, as the more points you ignore to fit the trendline, the less meaning the line carries.
The long-term trendline for Potash Corp. (POT) in Figure 3 extends upward from August of 2007 and passes through the lows in January 2008 and March 2008. These lows were formed with selling climaxes and represent extreme price movements that protrude beneath the trend line. By drawing the trendline through these lows, the upward trendline matches better with the other lows over this period.
Trendlines are a simple way to illustrate the trend of the market or an individual security. However, like any technical analysis tool, they can generate false signals if they are not used properly. Furthermore, trendlines should not be your sole decision-making tool. Using other technical indicators can help you confirm whether a change in trend is taking place.