Trendlines are a useful tool for visually highlighting a trend, and potentially being part of a trading strategy. There are a lot of myths and inaccurate information about trendlines though. Learning how to use trendlines effectively–if you are going to use them–is crucial so you don’t fall into several common traps.
Trendlines are a technical analysis tool used to define and project price trends in major markets such as stocks, forex, and futures. Trendlines have the potential to alert us when a pullback (move against the dominant trend) is over and the trend is resuming, or when a trend is accelerating or reversing (for more on trends, see Impulse and Corrective Waves). But price is the ultimate indicator. Therefore, price action (how the price itself is moving) must always be considered when using trendlines.
Here’s how to use trendlines for trading.
Monitor Price Movement of Trends
Whether you use trendlines or indicators, price action is what ultimately determines how much money we make. Learning about price action and how trends move is never a bad idea. Once we understand the basic concepts of how prices move, then trendlines become a more effective tool in helping us analyze that price action.
Prices constantly move up and down, even within a trend. While most traders know this, they have a hard time applying that knowledge in real-time. Traders often wait too long before entering, buying near the top of a price wave, or they panic as the pullback begins and end up getting out when the pullback is ending. Trendlines, discussed later, can help in this regards.
Figure 1 shows a basic uptrend. The uptrend begins by making a higher price high and then a higher price low (relative to the price waves that occurred prior). The price continues to make higher swing highs and higher swing lows. “Swings” refer to each major move up or down.
During an uptrend, we see this progress of higher swing highs and higher swing lows. When the price creates a lower swing high or a lower swing low, the trend is potentially in jeopardy. Once the price makes both a lower swing high and lower swing low (they don’t need to be in that order) then a downtrend could be underway–or it at least presents the possibility that we could see more downside. Trends can last for a long time and many waves, or they may only last a few price waves.
Figure 1. Higher Highs and Higher Lows – An Uptrend
During a downtrend, we see lower swing highs and lower swing highs. When the price creates a higher swing high or a higher swing low, the downtrend may be reversing. Once the price makes both a higher swing high and higher swing low (they don’t need to be in that order) it becomes more likely that the price could move further to the upside overall.
Pullbacks within larger trends, such as a pullback on a weekly chart, can often appear as trends on shorter time frames such as the daily or hourly chart (in figure 1, a pullback is the price move between the swing high and swing low). Even on the daily chart above, there are small waves within the larger labeled waves which haven’t been accounted for, which in real-time could cause some confusion. Reading price action is subjective; the basic concepts stay the same but how each person views the trend may vary slightly based on what they see and the time frame they are trading on.
Understanding the basic concepts of price action is crucial, because it applies to every trend we trade. If trading with a trend we want to see this type of movement–higher highs and higher lows for an uptrend, and lower highs and lower lows for a downtrend.
When a trend is no longer exhibiting these characteristics caution is warranted. It doesn’t necessarily mean the trend is reversing, but it does indicate a deeper pullback is occurring, or a reversal is potentially underway. Another key ingredient in reading price action is analyzing the velocity and magnitude of price waves, then comparing the velocity and magnitude of each price wave to the price waves around it.
How Trendlines are Useful for Trading
Price charts produce “noise.” Noise is the small random movements that can make it hard to spot the trend. Therefore, many traders prefer to simplify their charts. The uptrend in figure 1 is simplified by using a trendline, which highlights the trend and quickly shows the overall price direction.
This is very useful when looking at multiple time frames or when there are conflicting price action signals. By looking at the direction of the trendline traders can cut through the BS and see in which direction they should be trading.
Anytime there are two highs or two lows a trendline can be drawn. The trendline is drawn by connecting one high to the next, or one low to the next low. When starting out, draw as many trendlines as possible in all directions. This helps differentiate pullbacks and short-term trends from longer-term trends.
We also often have biases when we look at a price chart, which may not always be correct. By forcing ourselves to draw all relevant trendlines, especially at the far right of the chart (most recent price action), we may realize our initial bias wasn’t correct at all. Being able to see trends and pullbacks of different sizes will aid you in your overall analysis and chart reading abilities. This skill can then be applied to trading strategies based on price action and trendlines (see How to Day Trade Forex in Two Hours or Less).
How to Draw Trendlines on Your Chart
Trading software and charting platforms vary, but all of them should have a trendline or line tool. Select the tool. For an uptrend, connect the line from the low of one wave to the low of the next, and then extend it out to the right to provide a projection of where the next wave lows could possibly occur.
For a downtrend, connect the high of one price wave to the high of the next price wave and then extend it out to the right. The lines provide a projection for where future wave highs may occur.
If you are just starting out, TradingView.com is a free site with live real-time price charts, and great technical analysis tools.
Figure 2. Trendlines Drawn On a Chart
How to Use Trendlines for Trading – Adjustments Are Required
Trendlines are not only based on price, but also have a time element. This creates a great myth. Traders will often say that because a trendline is broken the trend is over. That is not true. The price could break through a trendline just because it look longer for a wave to complete. This is very common when the price is moving sharply higher or lower. For example, if the price is making rapid higher highs and higher lows, the trendline will be angled steeply upwards. That type of momentum can’t last forever, and eventually the trend will slow down. The price will break the trendline, but it doesn’t mean the trend is over, just that it has slowed down (as we should expect!). This is why we always consider price action in conjunction with trendlines.
Figure 3 shows an example of this. The price breaks the trendline but the price is still making overall higher highs and higher lows. It was crucial to monitor the price action, and not just the trendline, in order to see this was still an uptrend. The trendline was still effective in point a number of potential trade areas earlier in the trend (will be discussed a bit later).
Figure 3. Monitor BOTH Price Action and Trendlines
Trendlines will often need to be redrawn. They are not a perfect trading tool that tells you exactly where a trend will reverse. You will draw a trendline connecting highs or lows, only to see that the next price wave doesn’t match up with the trendline exactly. You now must decide if you want to redraw your trendline to accommodate these misalignments.
For a long-term trend, you may need to redraw the trendline multiple times. Alternatively, you may keep each of the trendlines you draw on your chart, showing the various stages the trend (near vertical, slow ascent, etc) has been through. This will remind you that conditions are always changing so don’t rely too heavily on the trendline… use price action analysis as well.
In figure 4, the price action isn’t very pretty, but trendlines help us see when the price is trending, when it is pulling back, and when it’s moving in a choppy fashion (no real trends present).
Ideally, if using trendlines for trading purposes you want to be trading assets with strong trending tendencies. A chart/asset like this one you would avoid since trading signals are harder to pick out. That said, for analytical purposes, trendlines help us see what is happening so we can strategize for the future (sometimes the best strategy is to not trade when conditions don’t warrant it).
Figure 4. Multiple Trendlines/Redrawing Trendlines, with Commentary
How I Use Trendlines in Trading
Instead of connecting exact highs to exact highs, or exact lows to exact lows, I draw trendlines of “best fit.” Trendlines only show us an “area” of potential interest, not an exact price level of interest. While textbooks show examples of beautiful trendlines where the price seems to magically bounce off them at exact levels, that isn’t usually the case in the real world.
A trendline of best fit connects as many highs together, or as many lows together, as possible. It is okay if the trendlines move through price bars (instead of running along exact highs and lows). The trendline still shows the overall movement of price, the trend direction, and provides areas of interest for potential trade signals (discussed next). The trendline also won’t need to be redrawn as often.
Figure 5. Trendline of “Best Fit”
How to Use Trendlines for Trading – Trade Signals
There are multiple strategies which could combine trendlines and price action. Here is one such simplified strategy:
—When the trend is up, if a pullback stays above the prior swing low and moves into the vicinity of the rising trendline, enter long (buy) when the price moves back to the upside (trending direction). Use a trade trigger to signal the actual entry, as discussed below.
—When the trend is down, if a pullback stays below the prior swing high and moves into the vicinity of the falling trendline, enter short when the price moves back to the downside (trending direction). Use a trade trigger to signal the actual entry, as discussed below.
Trendlines often need to be redrawn, therefore the price touching or moving through a trendline is not a trade signal on its own. We must also look at overall price movement. If the price movement warrants a trade it must produce a “trade trigger.”
A trade trigger is a precise event which tells us right now is the time to enter. The Engulfing Candle Strategy and the consolidation breakouts discussed in How to Day Trade Stocks in Two Hours or Less reveal entry techniques (trade triggers) and provide useful information for reading price action and using trendlines. These techniques are best used in conjunction with “trendlines of best fit.”
Trendlines help us keep focused and trading in the direction of the overall trend. The trendline provides an area where we should be on high alert for trading opportunities. This is especially true when using “lines of best fit” because multiple pullbacks have reversed near the trendline.
Fibonacci Retracements are also used in conjunction with price analysis and trendlines to find areas the price is likely to pull back to.
In the case of a downtrend, stop loss orders are placed just above the high of the current pullback. In an uptrend, the stop loss is placed just below the low of the current pullback. We can use the high and the low of the current pullback because we are entering once the price starts moving back in the trending direction.
Drawing Trend Channels
Connect highs to highs and lows to lows during a downtrend or uptrend and you may end up with a trend channel. As discussed above, a rising trendline (connecting the lows) during an uptrend can provide area of interest for seeking long positions. The line which connects the highs during an uptrend is also relevant. It lets you know where the price has had a tendency to pull back from, and therefore can aid you in picking a profitable exit for your trade.
When drawing trend channels, trendlines of best fit are recommended.
Figure 6. Trend Channel Using Trendlines of Best Fit
Using Fibonacci Extensions can also be used to determine exit points, as the extension levels are drawn based on recent price action.
How to Use Trendlines in Trading – TakeAways
- Trendlines are guidelines only, not exact levels. They provide areas the price could move to in the future. Don’t expect the price to move exactly to the trendline; it may not quite reach or it may overshoot.
- Price action is important, and should always be used in conjunction with trendlines. Always be looking for higher highs and higher lows in an uptrend. If a lower high or lower low occurs, the trend may be in jeopardy. Look for lower lows and lower highs in a downtrend. If a higher low or higher high occurs, the downtrend may be in jeopardy.
- Trendlines often have to be redrawn. You may end up with multiple trendlines at different angles for the same overall trend. “Lines of best” will reduce the need to redraw trendlines, although the best fit line may still need to be adjusted.
- Trendlines can be drawn anytime we have two waves in the same direction. When starting out, draw lots of trendlines as it helps show short-term and long-term direction.
- Trendlines are a visual guide to cut through noise, and therefore may aid in seeing trade setups. The trendlines themselves do not generate trade signals. Rather, we wait for a trade trigger near a trendline to get us into a trade aligned with the trend.
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By Cory Mitchell, CMT @corymitc