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In our previous couple of lessons we have focused on trendlines: we have learned how to identify the major swing points to draw trendlines and how to adjust a trendline. In this lesson we will turn our attention to strategies we could use when trading with trendlines. There after we will look at trading with trendlines and trendline patterns.

Basic Trendline Trading Strategies

In our previous lessons we have learned that trendlines are simple lines that connect swing points and that we need three swing point to touch the trendline for it to be a valid trendline. Once we have a valid trendline, we can start using the trendline as part of our trading strategies. Trading off a tentative trendline that only has two swing point touches is very risky as the trendline has not been validated yet. We always want to trade when conditions are in our favor. Hoping that the third touch will hold is not a good basis for a calm trade.

Once we have a valid trendline, be it an intermediate trendline or a short-term trendline, we should try to trade in the direction of the major trend as this is the path of least resistance. Use the intermediate trend and the short term trends for trading opportunities. If the major trend is bullish, look for opportunities to buy; and if it is bearish, look for opportunities to short sell. Remember that the major trend can also turn; if you cannot discern the major trend, don't trade. It may sound heroic to spot a trend reversal and ride out a successful trade, but clear trend reversals are fairly rare. A trend is often followed by a consolidation period where the market trades in a range that can make a trend reversal trade hard to mange. Besides, trading is not about being heroic, it's about reducing risk!

Having said that, there are two options when price action approaches a valid trendline to test that trendline: we could have a trendline bounce or a trendline break. Both of these options can become part of our trendline trading strategy.

Trendline Bounce

The most likely outcome of a trendline test, especially on the major trendline, is a trendline bounce. This occurs when the price action tests the trendline but fails to penetrate the trendline as the support or resistance in the area of the trendline holds. As a trendline bounce is the most likely outcome of a major trendline, it means trading in the direction of the major trend would provide greater success. Therefore, we always want to trade in the direction of the major trend. We would, thus, look to trade off the major trendline in the direction of the major trend. The question is where do we enter, where do we place our protective stop orders, and where do we exit?

We could close our trade when the major trend is broken, or when the intermediate trend shows signs of reversal again. The stop order also seems simple enough. As a break of the trendline would invalidate the trendline, we could place our stop order somewhere below the major trend line. Remember, though, that a price close on the other side of the major trendline is required to invalidate the trendline. As the major trendline would be based on a weekly or monthly chart, it might take a while for the price to close on the other side of the major trendline.

Fortunately, there are better strategies that we could use for our protective stop as well as our entry. And this strategy is based on a trendline break, but of the intermediate or minor trendlines.

Trendline Break

A trendline break occurs when the price action tests a trendline, manages to penetrate the trendline and closes on the other side of the trendline. This is trendline break is more likely to occur on an intermediate trendline or a minor trendline that moves in the opposite direction than the major trendline. This is because the support or resistance on a major trendline should be greater than that of an intermediate or a minor trendline. When an intermediate trendline or a minor trendline moves in the opposite direction than the major trendline, then the intermediate trend or the minor trend and the major trend are in different phases.

As the price action approaches the major trendline, the intermediate or minor trendline would be moving against the major trendline. We could anticipate a bounce off the major trendline, which would necessitate a break of the intermediate or minor trendline. We could, thus, use the intermediate or minor trendline for a better entry to a trade as well as better placement of a stop order as the intermediate and minor trendlines would be based on shorter time frame charts than the major trendline.

We would be trading off the intermediate or minor trendline. We would also be trading against the intermediate or minor trend but in the direction of the major trend. This allows us to enter a trade when the price action penetrates and closes on the other side of the intermediate or minor trendline. Our protective stop could be placed on the side of the test as a close back on the side that the test came from would mean our trade setup has been invalidated.

Using the intermediate or minor trendline means we can get a better entry point to our trade with a protective stop loss that should be relatively close to our entry while also allowing us to trade in the direction of the major trend.

Trendline Break and Retest

Sometimes a trendline break occurs too rapidly for a good entry point. In these circumstances the price may have moved too far away from our potential stop for a good risk/reward ratio. In these case it would be better to wait for the price action to retest the trendline. Although this does not happen every time, it does occur often enough, and if it does not occur we remain out of the trade and await another opportunity. Should a retest occur, we would be anticipating a bounce of the trendline which has now changed polarity with previous support becoming resistance and previous resistance becoming support. Here our protective stop would be placed on the other side of the trendline but our entry would still be problematic. We could look for an entry on a shorter time frame, or enter at a price level that is close enough to our protective stop so as to provide an acceptable risk/reward ratio.

We could also apply this strategy to a major trendline break. However, in such a trade we would be entering a trade against the major trend; this is fraught with danger as we would be trading against the major trend. Remember that a trendline break does not signify a trend reversal; a lower high and a lower low in a bullish uptrend, and a higher low and a higher high in a bearish downtrend would signify a trend reversal. A mere trendline break would signify that the major trend has weakened significantly, which could mean the major trend is coming to an end but it could be replaced by a non-trending, ranging market rather than a trend in the opposite direction. It is also quite common for a trending market to be replaced by a ranging market before a new trend emerges, and the new trend could emerge in the same direction as the previous trend or it could emerge in the opposite direction. It is for this reason that trading against the major trend is not recommended.

Conclusion

In this lesson we discussed a few basic trendline trading strategies based upon trendline bounce and trendline breaks. These are the only two possible outcomes when price action tests a trendline. What happens afterwards, however, is not guaranteed; therefore we should always have a protective stop loss in place. We do also know which outcome is more likely; the outcome that would be in the direction of the major trend. In our next lesson, we will look at a number of chart patterns that make use of trendlines, such as heads and shoulders, triangles and wedges.