It’s time to talk trendlines and I’m here today to help you remove the guesswork of drawing all different types of trendlines that help you pinpoint precision entries.
Few stock market sayings have more staying power than “the trend is your friend” and for good reason. When the trend is moving in the same direction as your trade, it’s like riding a wave on a sunny California day.
Trend following is one of the oldest technical strategies in the book because it helps eliminate the day-to-day noise of the market while providing setups for traders to get in and out of stocks with precision.
Of course, trendlines aren’t perfect and traders should be cautious to avoid confirmation bias. Remember, the key is to locate and follow the trend, not create one that matches our preconceived notions.
Otherwise you could wind up looking at stock charts that resemble the board Charlie Day used to find clues on Pepe Silvia in It’s Always Sunny in Philadelphia.
What Are Trendlines?
To put it simply, a trendline is simply a bounding line drawn on a stock chart using different support or resistance points in order to establish a general direction of price movement. Trendlines are drawn on an upward or downward angle in order to differentiate between an uptrend and a downtrend.
When a stock consistently makes higher highs and higher lows during the course of a trading period, it’s said to be in an uptrend. The trendline would be drawn connecting these higher highs to show that the stock has plenty of demand for shares.
In this instance, traders would look to buy shares while the stock bounces off one of these higher lows and then sell once a higher high is reached. Or, you can simply hold the shares and ride the wave of the trend until it peters out.
Conversely, if a stock is making lower lows and failing to top previous highs, a downtrend is likely occurring and the selling pressure will continue to intensify.
If you bought a stock in an uptrend and now see it consistently making lower lows, it’s probably time to reverse course, even if the fundamentals of your trading thesis remain intact. Fighting the trend is a good way to separate yourself from your capital.
Why Are Trendlines Important?
Trendlines might look random to the uneducated observer, but they’re really very useful tools for finding proper entry and exit points for trades. Not all trendlines have the same legitimacy. Oftentimes, what we think is a trendline is really just the randomness of the market.
But a good understanding of trendlines greatly enhances a trader’s ability to find support and resistance levels. We usually think of support and resistance as horizontal lines that converge on the same price point over and over.
But with a trendline, we can measure support and resistance levels while a stock continues moving in the direction of the trend. Instead of looking for a specific price as support, we look for the price to meet the trendline. This creates more opportunities to profit off of breakouts.
Trendlines are important because they give traders crucial information about support and resistance levels in volatile stocks. It’s easy to find entry and exit points when a stock is stuck in clear range-bound trading. But these points aren’t always crystal clear when a hot stock is in an uptrend.
Trendlines bring more clarity to volatile securities.
How To Draw Trendlines
There’s no right or wrong way to draw trendlines on a chart as long as you’ve got things moving in the same direction.
Your time frame and charting methods will depend on the type of trading you do – day traders might use 1-min candles while long-term investors use full days or weeks.
Additionally, some traders prefer using closing prices only while others like using the high or low of the day. The trendline rulebook isn’t a very long text, but you’ll need a few characteristics present to confirm the trend.
The first thing to look for are your anchor points.
These are the two points that connect the largest market moves during the current trend and give you an idea of where to look for resistance or support in the future.
Two points are necessary, but you’ll often notice trendlines connect three, four, or even five different market moves on a chart. When connecting points, we’re only interested in the largest market moves and they don’t need to match down to the penny.
Drawing trendlines are all about finding a zone and seeing if the current trend stays within it. Trendlines measuring upswings use support points while downswings use resistance points.
Making Decisions Off Trendlines
Utilizing trendlines in your decision making can help maximize your profits by locating exact entry and exit points along the current trend. For example, look at this chart of WORK since it’s IPO.
The stock consistently ran into resistance along this trendline from June through November in 2019. Shorting WORK along this time frame would have been a profitable trade if entered near one of these resistance points along the trendline.
But before December, the stock broke out of this trend and began to consolidate before lifting higher beginning in February. Once the stock broke through to the other side of the trendline, we could tell the days of shorting WORK were over.
When a stock is following a trendline, it’s easy to locate the entry or exit points. Ignore the smaller moves and focus on the largest swings.
This is how sophisticated trading algorithms and automated systems initiate their positions in stocks, but you don’t need expensive hardware to trade off trendlines. Just the ability and knowhow to spot the trends and block out the noise.
Trendlines are by no means an exact science and many of them only look obvious in retrospect. Plus, you never know when the stock will buck the trendline and reverse course.
But trading off trendlines is all about riding the wave until it breaks. Trendlines make it easier to establish areas of support and resistance, which reduces the stress involved with finding entry and exit points.
Like any other trading strategy, trendlines aren’t perfect and even the best trading plan can be thwarted by market randomness.
Trendlines are another tool in the toolbox, possibly one of the best for both short and long-term traders. But they do have limitations and sometimes trends don’t materialize along neatly drawn lines.
To get the full utility out of trendlines, know how to spot the difference between an applicable trend and random market noise.