Friday, December 3, 2010

The Trend Line - technical analysis basics on Zignals

Technical analysis - The trend line
The trend line, which can also be referred to as the ‘Dutch line’, is a commonly used chart tool that helps investors judge the timing of trades. They are commonly used to judge entry and exit investment timing when trading securities. Investors inferr these signals based on the line’s relationship with a security’s price movement over a period of time. Successful TAs  also use the trend line to identify when possible reversals might take place and also when a change in a trend might occur. The trend line can be interpreted in many ways which makes it a versatile tool to help create and develop personal strategies.
What timeframe should I use to create trend lines?
It is essential to draw trend lines using a price interval period that aligns with your trading strategy. For instance, a short term day trader may use trend lines with time intervals as short as 1 minute. Whereas longer term traders will use the trend line with time intervals based on daily, weekly, monthly or even yearly prices. While the trend line can be used with a host of other technical indicators, namely the MACD and RSI, for this post we will focus purely  on security prices.
Lets get started: Go to  and access the chart tool:
1 - Locate an uptrending security using research, trading ideas, or by looking in the public chart gallery.
2 - Draw a line accross the lowest points of the trend. Make sure the line does not cross through any of the prices.
3 - You need at least two prices excluding the starting price (so three points altogether) touching your line for it to be a valid trend line. See diagram below.
4 – From day one using the trend line, decide whether you will use the opening and closing prices or the high and low prices to draw your line. In our gold example above, we use the high/low prices of each candlestick.

How do I use the trend line to identify potentially profitable buy signals?
We can see that Gold gained huge support from the market right after the second point of our trend line. Investors who established a position in Gold at this point (the entry point having been identified by the trend line) were rewarded handsomely over the following months. The price of Gold incresed 11% in the space of 50 days.
How do I use the trend line to close a position?
Some investors sell out of a position when a trend line is broken. This is when the price crosses below the trend line. This however, like any other indicator, is never 100% reliable. See example below. The trend line was broken at the very end of October yet the trend itself did not break. Investors who liquidated their position when the line was broken subsequently missed out on the 5.6% price gain the following week.
After the trend line is broken, what do I do?
Draw another trend line! Often, when a trendline has been broken but the underlying trend continues on, it provides investors with an opportunity to trade within the resistance and support bands (which is the area between the first and second trend lines.

Notice that the first and second trend lines, in this instance, formed a trading channel. This means that the prices remain within the boundaries of our two lines for a certain amount of time. Our first trend line acts as a resistance marker and our second trend line acts as a support marker. Keep in mind that this channel band becomes weaker the more that prices touch off the two trend lines. When this kind of pattern is recognised, traders can go long when the security hits the support floor provided by the second band and short the security when it hits the resistance roof provided by the first band.

A few key points about trend lines:

What differentiates a weak trend line from a strong one is the amount of times prices touch
but do not cross the line. A weak trend line with have 2 touching prices over a long period of
time whereas a strong trend line will have many prices touching it. In our example above, the
first gold trend line is strong. In addition to the three prices marked with a green circle, there
are another three that could have been marked.

Two price points can help identify a trend line but three price points (the starting price plus two
additional prices) are needed to confirm that it is a valid trend line.

A break in a trend line does not necessarily mean that the security’s trend has broken.

To begin finding and drawng your own trendlines, go to Zignals and give it a try. Start drawing trend lines for free on Zignals. When you feel like putting your newfound TA skills to the test, why not create and publish a strategy with us? It's free and could potentially earn you money from other members's subscriptions. Build a trading strategy for free on Zignals.
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