What are trend lines?
Trend lines are diagonal or horizontal lines drawn across specific swing points on a trend that represents support or resistance levels and help predict where the next touchpoint could be.
Let’s take a look at a chart (Figure 1) with a trendline:
See how the trendline is connected across multiple points throughout the trend? The next time price approaches the trendline, traders will expect a bounce and continuation or a potential break with some momentum in the opposite direction.
Figure 1
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How to draw lines correctly?
There’s a certain art to drawing trendlines correctly and efficiently. For most trendlines, you need at least two points to create a line but having three or more could create a more significant line where the next time price approaches it, a bigger reaction could take place.
Here’s an example of a trendline using two points (Figure 2)
Now that the line is established, we watch the action the next time the price approaches the trendline. A simple bounce from the trendline may be enough to indicate that the trend will continue yet a candlestick pattern, potentially coupled with Fibonacci and other tools could give more confirmation and create a higher probability of success.
A few things to keep in mind
Higher timeframes work best when drawing trendlines. Not only do they produce stronger and bigger bounces, but they also indicate bigger reversals when the trendline finally breaks. We will learn more about this in the next section.
Figure 2
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Trendlines are not perfect and while you may have 3 great-looking points, the fourth one could briefly penetrate the trendline before reversing with the trend. Never assume that the trend will stop at the trendline exactly, otherwise, trading would be considered a lot easier than it is.
Don’t try to force a trendline to fit. If it’s not happening, wait for clearer points where you can draw a much more defined trendline.
Higher versus lower timeframe trendlines
There’s no doubt that trendlines on higher timeframes lead to bigger results. For example, let’s assume that the average daily range on the EUR/USD is 80 pips. An intraday trendline break, one with multiple points and a fairly valid one could lead to a move that’s worth 30-40 pips on average. While more is possible and depending on the trend and the context, typical trendline breaks on shorter timeframes usually lead to corrections and not trend reversals.
Not far from it are trendline bounces on smaller timeframes. Such bounces indicate trend continuation but intraday swings may not be more than 20-30 pips per leg.
Now looking at a higher timeframe such as the daily, trendlines extend for weeks, months, and sometimes even years. Beyond their length which can give you a clear direction for longer periods of time, the more points that the trendline uses on the daily chart, the more significant it is. After 3 or 4 points, the trendline is valid and strong with the next price intersection either leading to a major bounce or a break and reversal.
Here, a bounce is likely to indicate a new leg in the direction of the original trend and one that could go on for days and weeks before any significant corrections. This is the advantage of using trendlines on a longer timeframe. On the other hand, a break could indicate a major reversal and a new trend that can be better traded using shorter timeframes.
Figure 3
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After establishing the trend on the daily and assessing whether the price is approaching the trendline, has already bounced, or broke the trendline, one can use smaller timeframes and draw trendlines with the goal of trading in the direction of the trendline.
Let’s look at some scenarios that can provide potential trading opportunities.
Let’s assume an uptrend on the daily chart with price approaching a trendline that has three significant swing points. Here, we have two possible outcomes, a bounce or a break. Now let’s say a Bullish Engulfing candlestick shows up, indicating a strong bullish signal. Now that we know that the odds favor a bounce from the trendline, we should consider a more specific entry by going to a lower timeframe and drawing a down sloping trendline. Even though the Engulfing candlestick has already shown a potential reversal, the trendline on the smaller timeframe will help further confirm this bounce from the daily trendline.
Figure 4
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The figure below shows the Daily Timeframe, whereby the price is testing the upward trend 3 times. The Price just formed a bullish (Figure 3) engulfing candlestick formation, which indicates a bounce from the trend. In order to have a clearer entry with further confirmations, we tend to look at the lower timeframes such as the H4.
Looking at the H4 timeframe, we witness a downward sloping channel within the upward trend. This channel was just broken through to the upside, which is also the bullish engulfing candlestick on the daily timeframe. We now have (Figure 4) more than 3 confirmations to enter a specific trade based on the strategy.
That specific trade would have made (Figure 5) approximately 2.82 risk to reward. However, always count for the position size in case the probability goes the other way.
Figure 5
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Trading around the lines (Reversal vs Bounce)
If the market is moving in a diagonal manner which means the market is in a trending phase, we have 2 possible scenarios: Either continuation of that pattern or reversal with a possible breakout.
Continuation (Bounce):
As the previous example has shown, we need at least 2 to 3 points at which a trendline is confirmed. Once the trendline is confirmed, then we can Figure 6) start observing.
It is preferable to gather more confirmations in order to trade the bounces such as Fibonacci retracements, possible divergence with indicators on a shorter timeframe, and even candlestick patterns.
Figure 6
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Reversal:
Another scenario is where the price breaks out of that trend, leading to a reversal scenario, whereby the trend is now canceled and a new (Figure 7) one is being formed.
Putting it all together
Price action is considered to be the infrastructure for technical analysis. We have strategies that are based on indicators solely, however without the basic knowledge of pure price action it will be really challenging to identify the current position of the market.
Figure 6
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