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 a trend line is and how to use it.
Creating a trend line helps traders identify whether prices on the market are rising or falling. It can be used as an indicator of when to buy or sell assets. In this guide, we’ll explain what a trend line is and how you can use them as part of your trading strategy to maximize potential profits.
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 these lines carry much significance. They indicate a start or break of a new trend in stock prices. Thus, Trend lines bring a discipline in your trading and also give you trading signals.
Understand What a Trend Line is
A trend line is a straight line drawn through historical data points on a technical chart. It represents the average movement of a stock or commodity over a period of time.
Trend lines are used by investors as a reference point when making predictions about future price movements. They help determine whether a stock or a security is trending up or down.
If we see a technical chart for a stock, we find that stock prices keep fluctuating up and low. Thus, a trading range is established. The trading ranges have highs and lows made at different times. We can draw a trend line joining these low and high price points.
A trend line is essentially an angled line on a chart that connects several price points to indicate the current direction of an asset’s price movement. It can be used to determine when it might be time to buy or sell a stock.
By connecting multiple price points, trend lines help traders visualize the current trends in assets’ pricing so that they are better able to make informed decisions about when to invest.
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 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 up trending security, a down trending security or for a trading range on the technical charts of stocks.
Once you’ve determined the direction of the trend, it’s time to plot your trend line. It makes one of the basic steps to stock analysis.
The first step is to choose two major points on the technical chart that will be used as anchor points for the trend line. It’s important to pick two points that accurately reflect the longer-term trend you want to trade.
After selecting these points, draw a straight line between them and use it as your trading trend line. Finally, you look for opportunities to buy or sell stocks whenever price touches or breaks through this line, as this may indicate an opportunity for a profitable trade.
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 made by that security.
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, they act as support for a security and the stock moves higher, support also moves higher and so moves your stop loss.
Down trending lines are quite opposite to the up-trending lines.
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 line.
How To Use Trend Lines in Trading
Identifying existing trends is key when it comes to trading effectively with trend lines.
The most common way to do this is by using the chart patterns analysis method. This involves reviewing a chart to identify price patterns and make predictions about an asset’s future price movement.
Once you’ve identified these patterns, you can use them to set your trend line and make profitable trades.
When a trend line is touched or broken, this can be an indication of potential trading activity and the opportunity for you to open new trades.
If price action touches the line, you should observe how it reacts to determine if there’s any potential for a trade. If price does not break through the line, consider waiting for more price action before entering any trades. However, if price does break through a trend line, then you may consider opening a trade accordingly.
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 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 kinds of opportunities were 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.
While trading with trend lines, it’s important to know where to place your stop losses and take profit levels.
You should look for strong resistances and support levels around the trend line before deciding a stop loss level if you plan to enter long and short trades respectively.
Furthermore, you should also consider safe targets for taking profits – example if the price breaks through a resistance level and gives minimal retracement of 1/3rd of length of the previous candles body, you can exit half position at that point towards safe profit goals.
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. 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 breakout.