In order to successfully trade using trendlines you must first understand a few key concepts.
Right after horizontal lines of support and resistance, trendlines are probably the most used tool to analyse price movement.
First of all let’s start with the definition.
What is a trendline?
According to Google, the definition of a trendline is:
a line indicating the general course or tendency of something, e.g. a geographical feature or a set of points on a graph.
Similarly, in trading terminology, a trendline is basically a line drawn connecting either tops or bottoms in order to show the prevailing direction of price.
In this way trendlines work as a visual representation of support and resistance, with the caveat that they don’t have to be horizontal lines.
A trendline connecting the tops of price movement can be called a resistance trendline. Likewise the trendline connecting the bottoms of price movement is called a support trendline.
Why are they important
Trendlines are very versatile, they can be used to show not only direction but also speed of price.
Regarding the direction, while a rising (or bullish) trendline clearly shows that price is going up, a falling (or bearish) trendline shows you that price is going down.
To find the speed of price however, you must look at the slope of the trendline. The steeper the trendline, the faster price is rising or falling. Do keep in mind that very steep trendlines don’t tend to hold very long, as price cannot maintain a high speed for longer periods of time.
Trendlines are also quite flexible since they can be used both in trending and ranging environments and also to identify chart patterns like triangles and flags.
In my view, the basis of a good trading strategy should always start with clearly defining support and resistance areas.
In that regard, trendlines are only second to horizontal lines of support and resistance.
How to draw good trendlines
The simplest rules for drawing a trendline are:
- The line must connect at least two points on a price chart;
- In an uptrend the line is drawn along the bottom of easily identifiable support areas (bottoms);
- In a downtrend, the line is drawn along the top of easily identifiable resistance areas (tops);
Some traders defend that in order to be valid, a trendline cannot be broken. Personally I disagree. Trendlines are just like horizontal levels, they should not be treated as exact price levels, but should instead be treated as zones. Sometimes price breaks a few pips through the line and sometimes the price reverses before reaching the line. That does not mean that the level is invalid.
What you should keep in mind is that broken trendlines are less reliable than unbroken ones. For instance, in my personal experience I frequently found that a resistance trendline was broken only to be respected on the opposite side as support and vice-versa. To me that proves that the trendline was valid.
How to trade using trendlines
To trade using trendlines you only need to know one thing. You need to choose a direction!
Basically you need to decide what will you do when price reaches the trendline. You only have two choices. Price will either hit the line and bounce back, or price will continue and break through beyond the line.
To help you decide there are several tools that you can use. You can use fundamental analysis and trade according to your fundamental beliefs. You can perform a technical analysis of the higher time frames and trade counter trend or you can trade with the prevailing trend. This decision is up to you and should be followed according to your trade plan.
Now lets discuss our two options. Lets first start with the easiest of the two. The bounce back.
How to trade a bounce
To trade the bounce you must simply choose a minimum distance from the trendline that you wish to enter into a trade and whenever price reaches that minimum distance you open your trade. You can use some tools that will open the trade for you or that will alert you when price reaches the level you intend.
There are some traders that prefer a little bit of confirmation before entering into a trade and they wait for a predetermined number of touches to the trendline in order to open the trade. For instance, you may only consider a trendline to be valid if price touched it three times and bounced back. In this manner you will only open a trade when price approaches it for the fourth time. From personal experience, waiting for this kind of confirmation has not worked well for me. However it may work well for you.
How to trade a breakout
The second option to trading using trendlines is the breakout. The breakout is harder because you must first define for yourself what a breakout is. Some definitions say that if price reaches a specific distance from the line one should already consider it a breakout. However others say that the candle of the time frame that you are analyzing must first close beyond the trendline for it to be considered a valid breakout.
These differences will impact your trading because your entry point will be different. Depending on the close of the candle may cause your entry to be taken quite far from the trendline. On the other hand, if you enter into a trade as soon as price crosses the trendline, you will find that many times price will reverse and stop you out.
That is why there is a third way that you can use to trade breakouts. It is the pullback. Basically it states that you do not enter into a trade if price breaks the trendline and not even if the candle closes beyond the trendline. You actually wait for price to close and return back to the trendline. Only then you will enter into your trade. The pullback is usually a safer method but it has the disadvantage that sometimes price just goes and the pullback never happens.
Trendlines are a very simple tool to use, you are simply connecting dots on a chart.
Hopefully this post will help you draw better and more reliable trendlines which in turn will make you feel more confident in your analysis and help you in your trading with trendlines.
If you wish to trade with trendlines, check out the Trendline EA robot I developed to help me trade. With it I just draw my lines, input my desired actions and leave the rest to the robot. It’s awesome.
Good luck and happy trading!