This is part seven of a series on technical analysis about trend lines. Click here for the series overview in part one. Click here for part two on the history of technical analysis. Click here for part three on an overview of candlestick charts. Click here for part four on basic candlestick patterns. Click here for part five on advanced candlestick patterns. Click here for part six on Bollinger Bands.
Trend lines are an important tool used in all parts of technical analysis. Chart technicians draw them over highs and under lows to show the basic price trend. They make it easy to see where the support and resistance levels are. Knowing how to interpret them enables traders to identify buy and sell signals based on overall patterns and trends.
Drawing trend lines
Chart technicians draw trend lines diagonally to connect at least three pivot points in the price. A line can be drawn between two points, but it isn’t technically a trend until it has been tested a third time. When the price touches a pivot point without surpassing it at least three times, a trend is indicated, and trend lines can be drawn to connect the three points. They make it easier to see which direction the price is trending in by clearly delineating the top or bottom prices of the range.
When choosing prices to use for the trend lines, traders may use the open, close, high or low price. The answer varies depending on the trader’s personal preference and style of investing. Other technicians may look at different lengths of time like five minutes, an hour, or even a year if they are focused on long-term trends. Trend lines are very versatile because they can be applied to any time interval or asset price to identify ongoing market trends.
Traders don’t always agree on which price points should be used to draw the lines. Some may use only closing prices, while others might use a mix of opening, closing and high prices. It’s also important to remember that drawing trend lines is just as subjective as reading any patterns or technical signals from price charts. The more you study technical analysis, the more you will understand how to draw and read trend lines. Practicing this technique will enable you to develop your own investing style that works for you.
Support and resistance levels
In most cases, chart technicians draw only one trend line on a chart. When a trend line is marking the bottom price of the range, it’s called the support line. On the other hand, it’s referred to as a resistance line when it marks the top price of the range. Support and resistance lines mark test levels to see whether a price will break out of the range it has been trading in, whether that’s above the resistance level or below the support.
In the case of a price that’s trending upward, traders usually draw a support line to show where the bottom prices are. This will enable them to see when the asset’s price drops below the bottom price, which could signal a bearish pivot. In the case of a price that’s trending downward, traders usually draw a trend line to mark the high prices. When the price starts to break above the resistance level, it suggests a bullish move could be about to occur.
When a price starts to approach a support line which connects three or more lows, demand for the security often increases as investors expect a bounce off that level. Traders who try to turn a profit on momentum stocks often look at support levels to see when the price falls to a low it is expected to bounce off. If the price doesn’t bounce off the low and instead breaks below the support line, it means the price is weakening, and investors aren’t interested even at the lower price. This is a warning sign that more selling could be just around the corner.
It’s a good idea to cross-check trend lines with volumes. For example, if a price breaks below a support line and selling volumes are high, it means investors are abandoning ship, and the price will likely continue to fall. Rising volumes after the support level has been broken suggests the previous uptrend is over and a new downtrend is beginning.
When a price breaks above a resistance level and volumes are high, it’s a bullish signal. As the price approaches and touches the resistance level, some investors might sell, seeing it as a signal that the price is about to fall back down again. However, when it breaks through the resistance level and volumes are high, it means demand is very high. The resistance level marks a sort of psychological boundary, so when the price breaks above it, investors are so bullish that the psychological aspect of the price movement isn’t even a factor.
Some investors see a break above the resistance level as a major buy signal because it suggests that the price will go even higher, possibly signaling a new trend and resetting the resistance level even higher. In many cases, when a price breaks through a resistance level, that trend line becomes the new support level.
Some chart technicians do draw two trend lines on a chart. When this is done, it’s called channeling, and the signals are interpreted a bit differently. Channeling can be especially helpful when a security is trading in medium volumes because traditional trend lines are usually taken into account with high or low volumes. Thus, when the volume is not particularly high or low, traders often employ a slightly different technique.
While traditional trend lines are drawn between three or more highs or lows, channel lines must connect at least four points—two highs and two lows. Thus, channels can also be helpful when there are only two highs or two lows with the rest of the trades occurring somewhere in between them.
Channels which designate an uptrend are referred to as ascending channels, while channels which are trading in a mostly downward direction are descending channels. Both types can also be referred to as trend channels.
There are some similarities between standard trend lines and channels. The signals are interpreted in similar ways, except volume is more of a factor in standard trend lines than in channels. Unlike standard trend lines, whenever the price exits the channel on either the upside or downside, a sell or buy signal is triggered.
For example, if the price breaks above or below the top or bottom channel, many traders will simply take a wait-and-see approach because the channel has been broken. However, they may sell when the price simply touches the top channel, assuming that it will fall back to the low point of the channel next. On the other hand, they may buy when the price touches the bottom channel, assuming that it will bounce and rise back toward the top of the channel. This method of technical analysis provides insight to help traders buy low and sell high, although as with all investing techniques, it isn’t perfect.