Trend line is a commonly used term in technical analysis. Knowledge of a trendline is an essential step for trading or investing in stock markets. Every market participant must know what is a Trend line and how to use it.
Trend lines are very easy to use in trading. It should be the first thing you do when you draw a technical chart of a stock. Though a very simple tool, they add much strength to your trading plan.
Trend lines give you target price and stop loss price for a trade. Breakouts or breakdowns of stock prices from a trend line carry much significance. They indicate a start or break of a trend in stock prices. Thus, Trend lines bring a discipline in your trading and also give you trading signals.
What is a Trend Line ?
By definition, Trendline is a line drawn on a chart of a security (stock, commodity, currency etc) or Index by joining the upper or lower price points. Trendline depicts the trend of the security. It helps to predict the future price movements.
If we see a technical chart for a stock, we find that stock prices keep fluctuating up and low. They may keep trading like this for short term, medium term or long term. Consequently, a trading range is established. The trading ranges have highs and lows made at different times. We can draw a Trend line joining these lows or highs.
To have a Trend line, you should join either only low points or high points. Do not join lows to highs.
To have a more reliable Trend line, you need to ensure that maximum number of points are touching the Trend line. The smaller the number of points touching the Trend line, the less reliable it is.
Trend lines may of several types like Linear, Exponential, Polynomial, Moving Average or Logarithmic. We shall talk only of Linear Trend line only as it is most commonly used by the trader and is more accurate in predicting the future prices.
How To Draw Trend Lines ?
We can draw the trendline for both, up trending security, a down trending security or for a trading range.
For an up trending security or stock, we join the lowest points made by the stock. An up trending stock makes higher highs and higher lows. So, a Trend line with upward trajectory is created. It can be used to buy a stock at appropriate price in an up trending stock.
In an up trending stock, a trader is willing to buy it so as to take the advantage of the trend but he is reluctant to buy it near the top. Risk is that prices have the tendency to retrace back before again moving higher. So, he will draw a trendline on the chart in such a way that it joins maximum number of low prices touched by that security.
You can see in below figure, there is a daily chart of Heromotocorp stock which is in continuous uptrend since July, 2013.
We have drawn a line joining the lower points which we can continue to extend further as more prices appear on the chart. In an up trending stock, prices are expected to move higher and in order to capture maximum move, the trader will look to buy it at dips. At how much dip? Trend line helps to decide that.
You see whenever prices retrace after moving higher, they continue to bounce from the trendline. So, we can take a trade by buying the security when it comes closer to the trendline in anticipation that prices will rise again.
We will be riding the trend till our targets are met or the security closes below the trend. That is when the closing price of the security is below the trend line in a trading session. Thus, trend line act as support for a security and the stock moves higher, support also moves higher and so moves your stop loss.
Similarly, Figure above shows the daily technical chart of down trending State Bank Of India (SBI) stock where the stock tries to move higher and retraces back after striking the trendline.
So short selling traders enter the trade when stock moves higher and comes near the trendline, anticipating further price fall. Here also, the trendline acts as resistance point for the price and traders enjoy the move till stock remains below the trend line.
How To Use A Trend Line For A Trade ?
We discussed above that we can use Trend Line for initiating a trade. Let us take the example of a stock in the image below. The stock was consolidating in a small trading range. We draw a Trend Line joining the highs of that trading range.
One day, break out takes place above the Trend Line and the stock sees strong surge in prices. As a trader, you need to keep reading the technical charts daily. In that case, if you have hawk’s eye, you can spot those kind of opportunities wee in advance.
Whenever, there is a breakout, you can initiate a long trade. Generally, it is assumed that the breakout is more meaningful if the stock is able to close above the Trend Line and with more than average trading volumes. But you can take a trade for intraday trading if there is fresh breakout from the trend Line.
Use of Channels
Trend lines can be used to draw channels also. Channels are made up of two parallel straight lines. Channels also offer a very good trading opportunity.
One line of the channel touches the highs or lows of a stock. This makes a trend line. The other parallel line may or may not touching the lows or highs respectively as with first line of the channel. But it should be touching at least one point while we draw a channel.
If we find a stock trading in a channel, we take a trade assuming the stock will continue trading in this channel. See in the above image, a channel (upward trajected) with stock prices trading inside the channel line.
In upward trajected channel, we can buy the stock near the lower channel line. Our target is prices corresponding to the upper channel line.
For downward trajected channel, we can short sell the stock below the upper channel line. Our target price is the stock price corresponding to lower channel line.
When the prices break out of the channel, they offer a much stronger trading signal. The direction of the trade is towards the side of the break out.