Trends and Trendlines

A trend is a general movement in a particular direction. A market trend is a tendency for security prices
to either move up or move down. Sometimes, they move sideways, but the big profits are usually made
in either an uptrend, where successive price bars generally have higher highs and higher lows than
previous bars, or a downtrend, where successive price bars have lower highs and lower lows than
previous bars. A sideways market is often called a whipsaw market, because it is almost impossible to
tell which way it is going to go. Some traders try to profit in a whipsaw market by buying at support
levels and selling at resistance levels, but profits are strictly limited by trading costs, such as
commissions and slippage, and by being wrong often. It is easier to make a profit in an uptrend or
downtrend, and the profits are generally bigger. Furthermore, it is obvious that if the market or security
is trending, then support and resistance lines, by necessity, will also trend in the same direction. So the
first step to increasing trading profits is to recognize the trend.

Why Do Markets Trend?

The random walk theory of stock prices states that stock prices fluctuate randomly. This is true to some
extent, at least in the short term. But there is no doubt that markets and security prices do trend—one
only has to look at graphs of prices over time to see that trends are real. But if trends are real, then
there is a bias in changing security prices. In an uptrend, it is more likely that prices will rise than fall,
and vice versa in a downtrend. So, the trend really is your friend. If you knew that a coin was weighted
so that heads would come up more often than tails, it wouldn't make sense to bet on tails. Likewise,
more profits will probably be made by going long in an uptrend or short in a downtrend than betting

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against the trend, unless, of course, there are particular fundamental reasons for going against the trend
for particular stocks, commodities, or currencies, or other investments.

A common anecdote, true to some extent, is that markets trend because of uninformed traders, who
constitute the majority of the traders and have the most money as a group. Therefore, they have the
most influence on the market. Uninformed traders are those who don't know the efficient market
hypothesis, or what the intrinsic value of securities are, nor any other methods of security valuations,
except maybe a few financial ratios, such as the venerable price/earnings ratio. Nor do they much care.
They trade based on emotion. When the market is rising, more and more people start investing. They
start making money, they tell their family and friends, and become increasingly confident that they will
continue to make money. Their family and friends feel like they are missing out, so they, too, invest in
the market. But eventually, they run out of money to invest. Everyone who could invest has already
invested what they could, and so there is nothing to keep the market going up. Alas, it starts to turn
down. At first, most people think the market is taking a breather—it is consolidating—but, no, it just
keeps going down. And as it drops further, people increasingly become pessimistic, and as they sell
more and more securities, often at a loss, the market drops further, and they become more pessimistic
still. Until pessimism has reached its peak, and the uninformed players have sold all their holdings, most
at a substantial loss. Only the informed players who see the market as being cheap prevent it from
falling even farther.

The Recent Past

No doubt, the above scenario is true to some extent, although it is impossible to quantify the effect. But
there is another reason why markets trend—because of the interconnections of the economy. As I sit
here writing this in March 2009, the market indexes have dropped by more than half from their peak in
October 9, 2007. Since the peak, the market has been trending downward. Why?

First, it became apparent that many subprime mortgages were defaulting. This didn't hurt most lenders
too much at first since they securitized the loans and passed on the credit default risk to the investors of
these mortgage-backed securities. The increasing defaults caused credit rating agencies to downgrade
mortgage-backed securities, which lessened their value. Then some banks and finance companies
started failing, because it became increasingly apparent that banks and finance companies were major
buyers of these mortgage-backed securities.

With credit rating downgrades, they had to write down the value of these securities, which reduced
their own credit rating, and called into question their own viability. So many companies who bought
bonds of these distressed companies entered into credit default swaps, which promised to pay the
bondholders the principal should the bond issuers default.

However, many of the CDS issuers, such as AIG, saw it as easy money, figuring they could collect the
premiums and never have to pay out on the swaps. But they did have to pay out, and it became
apparent that they would have to pay far more than they possibly imagined, which threatened their
existence as a going concern. Then banks started to restrict loans to each other and to others not only

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because they couldn't be sure who would be impacted by these securities but also because they, too,
were being impacted by the bad loans.

So, they stopped lending to protect their own capital. The price of loans shot up to new highs, both for
businesses and consumers. Businesses cut back on new projects and lay off employees so that they
could conserve their capital. The unemployment rate reached new highs, which caused consumers to
cut back spending to conserve their money, which, in turn, caused businesses to cut back further
because of reduced business. Then credit card companies started raising rates and closing accounts
because they couldn't be sure who was going to be affected by all this unemployment. Furthermore,
nobody was buying any more asset-backed securities which supplied the backing for auto loans, student
loans, and credit cards, which reduced the availability of credit, and, thus, the money supply. This
caused consumers and businesses to lower spending even more even as the price of just about
everything was falling.

Now, with unemployment at its highest peak in 25 years, it will be some time before the economy starts
growing again. What this shows is that the economy has both inertia and synergism. When the economy
moves in a particular direction, most businesses and consumers are affected.

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So, what happens from here?

Right now, businesses are cutting costs and people, and people are holding back from making major
purchases, such as cars, hurting business even more. But at some point, it will turn around. People can

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delay purchases to some extent, but eventually they'll have to make them. Slowly, people will start
buying more, which will slowly increase business. Businesses will grow, their profits will rise, and so will
their stocks as more people become confident. When they see the market rising, then they'll also start
investing again. All of this will take time, and that is why the market trends.

When the economy is rising, people have more and more money, causing them to spend more, and
thereby increasing business for everyone until it can go no higher—positive feedback. And when it is
declining, then negative feedback keeps it declining until it drops no lower. Since the economy cannot
change direction quickly, neither do the markets, which are directly affected by the economy.

So, recognizing the trend and trading with the trend rather than against it is the key to making the most
profit. Go long in an uptrend, go short in a downtrend. Greater profits can be made the earlier the trend
is recognized.

The Geometry of the Trend

The trend is never a straight line, but a direction, and sometimes, the trend pauses, and gets stuck in a
trading range. Sometimes it reverses for a short time, in what are called retracements, pullbacks, or
corrections. The erratic nature of the trend is caused by the fact that the economy does not move at a
constant speed, and supply and demand, which determines prices, fluctuates from moment to moment
and from day to day. These fluctuations give rise to the short and intermediate trends that punctuate
the long trend in the market. So, trends have are fractal—there are trends within trends.

Trendlines

To recognize the trend better and to decide at what prices to enter and exit a trade, traders often draw
trendlines. A trendline starts at the beginning of the trend and terminates at the end or wherever the
market happens to be currently. To maintain accuracy, trendlines should be updated as new prices
become available. When the trend changes, then a new trendline must be drawn to represent the new
trend.

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There are, however, several ways of drawing trendlines that will have slightly different directions for the
same trend depending on how the trendline is drawn and what type of chart is used. A trendline can be
drawn so that:

A lowest low at the

beginning of the trend is
connected to the low of
the highest high at the
end of the trend, which
is usually how
trendlines are drawn for
uptrends. This also
forms a resistance line.

The high of the highest

day can be connected to
the high of the lowest
low day, which is how
downtrends are
frequently drawn. This also forms the support line.

Trend lines are lines drawn at an angle above or below the price. They are used to give indications as to
the immediate trend and indicate when a trend has changed. They can also be used as support and
resistance and provide opportunities to open and close positions.

A prominent high or low at the beginning of the trend can be connected to a prominent low or high at
the end of the trend.

Sometimes a low or high can be abnormally large compared to neighboring lows or highs, so trendlines
are often drawn using closing prices to give a more accurate picture of the trend.

Here are some more trend line tips

▪ The more times a stock touches a trend line, the more significant it becomes.

▪ It takes two touches to draw a trend line, but 3 to confirm it as being a valid one.

▪ In a down trend, draw the line along the highs of prices.

▪ The steeper the trend line, the less reliable it will be.

▪ A trend line break does not mean that the trend will change.

They are just a piece of the puzzle.

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Linear Regression Line

Trendlines connecting highs and lows actually flank the true trendline, which is the line that would run
through most of the middle of the price bars. The linear regression line, which is unique for any given set
of prices, is a line that best approximates the fluctuation of prices in a specific time period as a single
line, and its slope is the trend for that time. Specifically, the linear regression line is drawn so that the
sum of the differences of each price point—usually the closing price, but other prices can be used—to
the line is minimized.

Linear regression lines are time-consuming to calculate manually, but most charting software can
calculate it automatically. Spreadsheets, such as Microsoft Excel, can also display linear regression lines.

Linear regression lines are best used to depict an uptrend or a downtrend only. A graph that consists of
both an uptrend and a downtrend, or even a trading range will be more horizontal and would not be an
accurate approximation of a specific trend.

Support, Resistance, and Consolidation

During the trend, security prices will usually oscillate between the support and resistance lines. As the
price drops to the support line, traders will buy the stock, anticipating a slight rise in price, and when
prices rise to the resistance line, traders will sell, anticipating that it will drop back to at least the mean.
Support and resistance lines exist even in areas of consolidation or congestion, where the trend is
sideways. Eventually the consolidation will begin a new trend or continue the old trend.

Trend line as support or resistance

If a trend line has been identified and it is holding as support or resistance, then you can use the trend
line to enter into the market once the price comes back to it.

Using the Trend to Trade

Although it is generally easy to see the trend from looking at past prices, it is impossible to know when it
will end. Therefore, the trend is always used with other indicators, especially for short-term trends. For
changes in the long-term trend it is best to keep abreast of the news to see how the economy is doing,
since it is the state of the economy that determines the long-term trend.

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There are two predominant methods in which to trade using trend lines:

• Entering when the price finds support or resistance at the trend line

• Entering when the price breaks through the trend line

Trend line as support or resistance

If a trend line has been identified and it is holding as support or resistance, then you can use the trend
line to enter into the market once the price comes back to it.

1. Short entry after the price finds resistance at the trend line

2. Stop loss above the trend line

The chart above shows the trend line being used as resistance and the price using it to find an entry.

A stop loss can be put on the other side of the trend line. The size of the stop loss depends on the
strategy involved.

Trend line break

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The trend line break method uses the actual breakout of the line to determine an entry. When the price
breaks through a trend line, it is no longer valid as support or resistance and it is likely that the price will
continue to reverse direction.

There are two ways to enter using a trend line break: an aggressive entry and a conservative entry.

An aggressive entry

An aggressive way to enter using a trend line break is to enter as soon as the candle breaks through and
closes on the other side of the trend line.

1. Short entry after the price broke through the trend line to the downside

2. Stop loss is placed above the trend line

The chart above demonstrates that once the candle closes on the other side of the trend line, then you
can enter immediately. A stop loss can be placed on the other side of the trend line.

A conservative entry

A more conservative way of trading the trend line break is to wait until the price has broken through the
trend line and then tested from the other side as either support or resistance.

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 1. Price breaks through the trend line to the downside

2. Wait for the price to come back to the trend line and find resistance

3. Once determined that the breakout is true, enter into a short entry

4. Stop loss is placed above the trend line

The chart above shows a trend line that has been broken after acting as support. The price then tested it
from the other side as resistance, further confirming that the breakout is likely to continue. After the
trend line has been tested as resistance, you can enter a short position and place a stop loss on the
other side of the trend line.

Caution using trend line breaks

In order to trade a breakout of a trend line, it is a good idea to wait until a candlestick actually closes on
the other side or tests the other side of the trend line as either support or resistance. Without a close on
the other side of the trend line, it is generally not considered an actual break.

1. False breakout

In the above chart, the price moved below the trend line. However, it retraced, and the candlestick
closed above the trend line. If a trader entered as soon as the price broke through, it would have been a
losing trade.

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 Summary
So far, you have learned that:

• trend lines are drawn at an angle and are used to determine a trend and help make trading
decisions.

• in an uptrend, trend lines are drawn below the price and in a downtrend, trend lines are drawn
above the price.

• to draw a trend line in an uptrend, two lows must be connected by a straight line.

• to draw a trend line in a downtrend line, two highs must be connected by a straight line.

• a trend line should be connected by at least three highs or lows to make it valid.

• the more times the price touches the trend line, the more valid it is.

• trend lines can be used as support or resistance, in which case you can enter trades when the
price touches the trend lines.

• another way to trade using trend lines is a trend line break, where the price breaks through the
trend line.

REMEMBER TRADING CARRIES RISKS. ALWAYS KEEP THIS IN MIND

If you do not understand the risks seek professional advice and do not trade until you understand. You
could lose all of your funds and face additional risks.

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