Trading With Trendlines | FXTRADING.com - International

Trading With Trendlines

Admin, November 19th, 2020

Trendlines are likely one of the oldest forms of trend analysis. They were popular long before the advance of computers as charts were literally drawn by hand, and the trendlines were drawn with a pencil and ruler.

But as easy as trendlines are to draw, a trader’s success is defined by how they react to price action and not by how they drawn lines on a chart. So today we will cover the basics of trendlines and how they can be traded, using hypothetical examples on historical charts.

 

How to Draw a Trendline

It is generally accepted that a trendline needs to touch three peaks, or three troughs to be validated. However, a bullish trendline can be drawn as soon as a higher low (HL) forms and a bearish trendline can be drawn when a lower high (LH) forms. The trendline is then projected into the future and will be confirmed upon a third successful touch. If prices break through the projected trendline it becomes invalidated.

As with horizontal support and resistance levels, the longer a trendline holds the more reliable and significant it is considered to be. This makes sense, as more traders have had the potential to spot the trendline and react around it. Yet the inverse is also true. If an established trendline breaks (as they always do eventually) the more significant the potential reversal is considered to be.

The highs and lows of that chart are frequently used to draw the trendlines, although line charts can also be used with success. As we mentioned in our line chart article, large traders who have the ability to move prices pay attention to the closing price of the daily, weekly and monthly charts, so it can be beneficial to also perform trendline analysis on a simple line chart.

To select the trendline tool within MT4, select the icon with a straight line pointed at a 45° (degree) angle.

By default, the trendline tool will project a line indefinitely into the future called a ‘ray’, which makes it easier to project future support and resistance. However, there will be times when the ray feature is not required.

To remove the ray feature, double click onto a trendline and untick the “Ray” button under the “Parameters” tab.

 

Trendlines in Practice

Trading a Trendline
Trading in line with the trendline can be seen as a form of swing trading, which is clearly in line with the dominant trend. Ultimately the trader is looking for evidence that a new trough has formed on a bullish trendline before entering. Conversely, they would want evidence that a peak has appeared on a confirmed bearish trendline before trading it.

  1. NZD/CHF was trending higher with a series of higher highs and lows.
  2. A lower low (LL) formed to warn of a change in trend. Yet as price action remained above a nearby bullish trendline, the change of trend warning appeared weak.
  3. A bullish candle confirmed the bullish trendline with a third successful touch. However, as it was a bullish engulfing candle it strongly suggested a swing low is in place. The trader decided to enter a buy-stop order above the engulfing candle with a stop loss beneath the trendline and swing low.
  4. Two days later the order was triggered. Whilst the bearish hammer was a slight concern the trader decided the trend is more important than a single bearish candle.
  5. Two days later a bullish outside day formed above the trendline and momentum realigned with the trend.

As for stop management, traders attempting to ride the longer-term trend could consider trailing their stop behind the trendline. However, a swing trader would likely use a tighter stop as they are generally trading the swings within the overall trend.

 

Trading a Break of a Trendline:
Whilst a break of a trendline invalidates it, a broken trendline can also create opportunities counter to the original trend.

The trader must decide how much confirmation is required to invalidate the trendline. A more aggressive approach would be to enter on the actual break using a market order. Although they may want to decide in advance a threshold required the trendline should be broken by. For example, they could use a certain level of pips, points or a percentage clearance of the trendline before seeking to enter.

Alternatively, the trader could wait for a close confirmation. This would require the breakout candle of the current timeframe to close beyond the trendline before entering a trade. Or perhaps they want to see at least two or more candles close beyond it.

  1. A bullish candle confirmed the blue bullish trendline with a third touch. However, the subsequent rally from the trendline was short lived.
  2. A bearish session pushed AUD/CAD comfortably below the trendline. The trader decided to enter the breakout using a live market order to enter short. Whilst prices pushed lower throughout the session, it closed about 1/3 of the day’s range off-of its lows. This is typically the kind of price behaviour we would expect from a breakout, so the trader could decide whether to close out for a small profit or remain short to see of bearish momentum returns.
  3. A large bullish candle clearly showed the break of a trendline had not worked out on this occasion.

A third approach is to enter a retracement towards a broken trendline. This is the most conservative approach of the three as it requires extra confirmation. In doing so, the trader has an opportunity to enter during a period of lower volatility and miss out the emotional hype that a breakout can bring. The disadvantage however is there will be occasions where the market does not retrace towards the broken trendline, and the trader must watch the market accelerate from a potential entry point without being involved in the trade.

Using the same example as above, we assess how the trendline break could have been approached by instead waiting for a retest of the trendline for extra confirmation.

  1. A large bearish bar invalidated the blue bullish trendline. The trader decided to wait to see if the trendline was retested before entering short, to avoid entering a fakeout.
  2. After retracing towards the trendline, a bearish hammer formed and its high perfectly respects the trendline. The trader decided to enter a short sell-stop order beneath a cluster of candles, with a stop loss above the trendline and hammer high.
  3. The next day saw a large bullish candle form. The trader cancels their sell-stop order as it has not been triggered.

 

Accelerating trendlines
Whilst it is generally accepted that three touches of a trendline are required to confirm it, there are times where the third touch never occurs as prices accelerate away from it. This is in fact a sign of strength as it shows underlying momentum is increasing in the direction of the current trend.

  1. A trendline was projected into the future, to help identify a potential trough ahead of time.
  2. A 3-bar bullish reversal (morning star reversal) appeared before it retraced to the initial trendline. This suggested a swing low was in place and momentum was increasing.
  3. Before prices retraced towards the prior two trendlines, a 2-bar reversal with a bullish engulfing candle appeared to suggest the trend is accelerating even faster.
  4. The third trendline was confirmed with a third touch and the trend continued.
  5. An intraday spike breached the purple trendline. At this point the trader would have had t decide whether this invalidated the trendline
  6. Interestingly, prices fell sharply from recent highs after the intraday break of the bullish trendline. Also note that prices closed just below the trendline. Whilst it was not perfect, traders were clearly watching the trendline, which also provided resistance the following session.
  7. Prices moved lower and the decline stalled just above the second trendline. Had prices rallied from current levels and tested the trendline, the darker blue trendline would have been confirmed 2-months after the initial trough.
  8. A bearish engulfing candle formed and closed just below the original trendline. Again, whilst it didn’t perfectly respect it, the volatility of the bear market should be taken into account. But it does show traders were watching the original trendline to see if it would hold. The following session also used the original trendline (now broken) as a resistance level.

 

Minor breaks / breaches of the trendline
A purist would argue that there should be no price action on the wrong side of the trendline, as any such breach invalidates it. We would suggest this is up for debate and depends on the market traded.

For example, if a trader uses actual data from a stock market exchange then perhaps they should be stricter with the accuracy of their trendlines. This is because official exchange data should look the same to all traders across all platforms. And it could be argued that line charts provide more accurate and cleaner trends on-line charts of the daily, weekly and monthly charts.

However, as forex prices are not traded via an official exchange and instead determined by a network of dealers, discrepancies can and do occur when platform providers and brokers are directly compared. This means the high and low does not always match which can have an impact of what the ‘actual’ swing high or low is. Therefore a good rule of thumb, particularly if using trendlines on forex, is to allow for some ‘noise’ around the trendlines. With this in mind, we think it is okay for breaches of a trendline to occur, so long as they are not too often and too extreme.

  1. A trendline ray was projected into the future between the June 2018 high and the third lower high (LH3) of the current downtrend.
  2. Prices turned lower in line with the dominant trendline, although this new trendline was yet to be confirmed.
  3. Prices began to retrace towards the trendline
  4. A large bullish bar pierced the trendline. However, the trader decided to wait for the day to close before invalidating the trendline. As the session closed beyond it, the blue trendline was invalidated before it was confirmed.
  5. Choppy price action occurred over the next few sessions. When prices turned lower, a new trendline ray was projected for future.
  6. A period of choppy, sideways action moved prices towards the purple trendline.
  7. A bearish outside candle marked a prominent swing high and prices move lower. The trendline was confirmed as this was the third touch.
  8. A minor intraday candle pierced the purple trendline. The trader chose to ignore the breach as the day closed beneath it and formed a doji.
  9. Three trading days later a large intraday spike pierced the bearish trendline. However, as the day closed beneath it and formed a bearish pinbar, the trader chose to keep the bearish trendline in place.
  10. A distinct Marabuzo candle clearly broke above the purple trendline and invalidated it.
  11. The trader was no longer seeking bullish opportunities as the bearish trendline was clearly broken. Prices retrace towards the trendline but do not retest it. However, a bullish engulfing candle formed a part of a 2-bar reversal to suggest the retracement is complete.

 

Some Markets Simply don’t Like Trendlines
There will be occasions where a market behaves like it wants to conform to a trendline, yet repeatedly creates noise around whether you think the trendline should be. This can result in the analyst or trader repeatedly updating their trendline as price action evolves and can create a lack of confidence in the trendline. A simple way to deal with this is to accept that markets don’t actually have to respect trendlines, and if you are struggling to place the trendline then chances are it shouldn’t be used. Basically, don’t try to force a trendline on a market that doesn’t pay them any respect.

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