Using Trend Lines to Define Rate of Trend
Trend lines are one of the most used and abused tools in modern technical analysis. One good working definition of a trend line is a line drawn between two points on a chart, but then there are the internal trend lines, which can be drawn anywhere through the middle of price bars. There are many possible variations of these lines, but the one rule is that however the trader chooses to define trend lines, they should be used and applied consistently.
The Standard Trend Line
Standard uptrend lines are drawn between higher lows in an uptrend; the standard downtrend line is a line drawn between lower highs in a downtrend. The uptrend line shows where buyers have stepped in on the declines with additional demand and have bid the market higher, which is why Wyckoff called this line the demand line. In a downtrend, the downtrend line, or the supply line, shows where additional sellers have come into the market to arrest the bounces. If you are drawing standard trend lines, be certain of these points:
- They slope with the trend. Uptrend lines are upward sloping, and downtrend lines slope downward.
- A is drawn between lows in a downtrend instead of between highs in a downtrend.
- B is also drawn between lows in a downtrend. Furthermore, it ignores a large price spike in an effort to fit the line to later data.
- C is more of a best-fit line drawn through the center of a price area. These may be drawn freehand or via a procedure like linear regression.
- D is drawn between highs in an uptrend.
- E raises a critical point about trend lines: They are lines drawn between successive swings in the market. If there are no swings, there should be no trend line. It would be hard to argue that the market was showing any swings at E, at least on this time frame. This trend line may be valid on a lower time frame, but it is nonstandard on this time frame.
In general, trend lines are tools to define the relationship between swings, and are a complement to the simple length of swing analysis. As such, one of the requirements for drawing trend lines is that there must actually be swings in the market. We see many cases where markets are flat, and it is possible to draw trend lines that touch the tops or bottoms of many consecutive price bars. With one important exception later in this chapter, these types of trend lines do not tend to be very significant. They are penetrated easily by the smallest motions in the market, and there is no reliable price action after the penetration. Avoid drawing these trend lines in flat markets with no definable swings.
The Parallel Trend Line This useful tool is built in three steps:
1. Draw a correct, standard trend line.
2. Create a parallel line. (Most charting packages will allow you to clone the line, but you can accomplish the same thing by drawing the trend line, dragging it away while preserving the angle, and then redrawing the original line.)
3. Anchor the parallel line to the opposite side of the trend. (In an uptrend, it should be attached to pivot highs, and to pivot lows in a downtrend.) It is very important that it is anchored to the most extreme point between the two initial anchor points for the standard trend line. The parallel line must not cut prices between those two initial points.
The purpose of the parallel trend line is to create a trend channel that shows the range of fluctuations that the market has accepted as normal. In general, if you are long in an uptrend and prices rise to the upper parallel trend line, it probably makes sense to be slightly defensive and to take some profits. The same idea applies, inverted, to down trending markets. Of course, the market can take out the parallel channel and continue, but this is frequently an area where there is additional volatility and heightened potential for reversal.
Figure 3.36 shows an example of a parallel trend line on weekly bars of the S&P 500 Cash index. A few points to consider: The long dotted line is the parallel trend channel, which was drawn at point A on the chart. This is important; the line was in place in mid2010, so it provided an already-established reference going into 2011. Note that the partial line marked B is not correct because it cuts through prices between the two attachment points for the standard trend line. Most importantly, notice the price action at the points marked C, which provided clear reference points to reduce long positions or even to initiate aggressive shorts.
There are, broadly speaking, two expectations for price action near this line. In the first case, prices reach the top of the channel and pause or back off, as in Figure 3.36. Depending on your style, you may or may not want to attempt to fade the trend at the line, but this is difficult because there are usually no logical and clearly defined risk points. Trades like this may be overly aggressive, but it should at least be a reasonable spot to reduce exposure and to book partial profits. It is important to monitor price action around these levels carefully, because there is the chance that the market will pause, consolidate, and then press through the channel. When this happens, it is a strong vote of confidence from the dominant group in the market (buyers in uptrends, sellers in
downtrends) and often leads to a new trend that proceeds at a faster rate. Figure 3.37 shows an example of this phenomenon in silver futures. This is a good example of what people mean when they say “reading the market tape,” which is, in part, judging how the market acts around critical levels. A key component of this is price action on lower time frames, which can only partially be inferred from the trading time frame. A complete understanding requires inspection of several lower time frame charts, and, ideally, monitoring in real time as the action develops. If you found yourself short after point A in Figure 3.37, it would have been relatively easy to see that you were on the wrong side of the market. What should have happened, if your short was correct, was a fairly immediate meltdown. Being responsive to information often allows a trader to reduce losses on losing trades, and, ideally, to position on the correct side of the trade.
One- to Three-Bar Trend Lines In general, the significance of a trend line depends on the significance of the points used to define the line. However, there are some special cases where very short-term trend lines may give good trading signals. Charles Drummond (1980) has used these short-term trend lines as the foundation for his Drummond
At some point in their development as traders, they may find that these small trend lines offer some interesting opportunities for precisely timing entries. The two-day line drawn from the day before yesterday’s low to yesterday’s high, and extended into today’s space on the chart will often define areas where the market is likely to exhaust itself in an overextended condition. (The corresponding downtrend line can be drawn from the day before yesterday’s high to yesterday’s low, and into today’s price range.) This line is not even a trend line proper, in that we do not look for the slope of the line to contain prices or to define the trend. Rather, the point where the line intersects today’s prices is a potential reversal or inflection point. As with all trend
lines, there is no magic here; it works because markets tend to oscillate within certain volatility levels that can be geometrically defined by the previous movements of that market. Figure 3.38 shows examples of these very short trend lines, but these are only a few isolated examples. One good application for these short-term trend lines occurs frequently in pullbacks. These pullback patterns often have fairly clean boundaries of support and resistance, and small trend lines can be drawn over, under, or touching multiple bars in a row. (This is an exception to the rule earlier that trend lines should define relationships between real swings in the market.) A very common pattern is to see these short-term trend lines violated for short periods of time, and for the recovery from that break to actually be the catalyst for a move in the opposite direction of the break. For instance, Figure 3.39 shows a clean buy off a (nonstandard) trend line at the bottom of a pullback in an uptrend. Normally, this would probably not be an attractive spot to initiate a long, as we try to avoid buying after a buying climax, but the duration of the consolidation was sufficient to work off the climax condition. The market consolidated long enough that it was reasonable to attempt a long trade. If you had been looking for a spot to buy this market, note how
the break of the very small trend line actually provides the entry point. You will have to decide how you want to manage the risk in these trades, but one simple way might be to wait for the market to recover back above the trend line, and then to buy with a stop just under the low of the bar that broke the trend line. It is always important to ask why a pattern should work. In this case, there is a good explanation. The little spike beyond the short-term trend line is a buying or selling climax on lower time frames, so it is a natural exhaustion point for the countertrend move. Furthermore, there will be traders who exit their positions when those trend lines are broken, and they will be forced to chase the market to get back in. Remember that trapped traders drive some of the best trades, and that traders can be as effectively trapped out of positions as in. The key to the success of this pattern is that the market should not spend much time outside the trend line. (The definition of “much time” depends on the time frame—if weekly bars, probably not more than two days. If daily bars, then probably not more than a few hours. But on a 1-minute chart, we would want to see prices back above the trend line in less than 30 seconds.)
Rate of Trend
Markets rarely trend at one simple, consistent rate. It is very common to see a trend line broken and for the original trend to hold, albeit at a more shallow slope. This is one reason why naively trading on breaks of trend lines can be frustrating; these breaks are often simply moves into another degree, level, or rate of trend.
Figure 3.40 shows trend lines redrawn to define the new rate of trend. This often has to be done many times in extended trends, leaving a characteristic fan of trend lines. It is also possible for a market to define a new, steeper trend. A common spot where this can occur is on a break beyond a parallel trend line, but this can also happen at any point in a trend if a catalyst further tips the supply/demand imbalance.
In Figure 3.41, Cotton futures slowly ramp into a trend that eventually ends in a parabolic climax, and ever-steeper trend lines must be drawn to contain the new trend. These greatly accelerated trends will eventually reach rates that are unsustainable, as they often end in minor climax moves. At some point, trend lines will be more or less vertical, and it is important to avoid attaching too much significance to a break of a nearly vertical trend
line. They are still useful from the standpoint that they do define the rate of the trend, but they are also broken easily and with impunity. However, if these trend lines are marking parabolic markets, it is important to be responsive to the possibility of a dramatic collapse. Trend lines may not be the ideal tools to trade in these areas, but they can point out important structures and areas to watch.
