Drawing Trendlines
In our previous module we discussed trends in the context of Market Structure and Dow Theory. Our attention now turns to Trendlines and how to draw Trendlines. This lesson builds on the previous module while also clarifying some of the ideas introduced in that module.
What are Trendlines?
Drawing Trendlines
A trendline is a simply a line that connects swing lows or swing highs and gives a trading bias; if the trendline is rising it means the trend is up and our bias would be to be bullish. If, on the other hand, the trendline is declining it means the trend is down and our bias would be bearish. It also indicates areas of possible support and resistance. This all sounds simple enough, but let's retrace to that definition of a trendline: a line that connects swing lows or swing highs. Some call swing highs and swing lows peaks and troughs or swing points. But what exactly constitutes a swing high or peak? And what constitutes a swing low or trough?
Swing highs and swing lows are often described as peaks and troughs, respectively, or as swing points, collectively. In this section we will use these terms interchangeably.
A swing points is simply a reversal point in a series of price bars or candlesticks on a chart. In other words, it is the point at which the price changes direction. In an uptrend you would expect each price bar to make a higher high but some will make a lower high. This is a swing point in an uptrend: a bar with a high that is higher than the two price bars on either side of it as shown in Figure 1. This is also a swing high or a peak. In a downtrend it would be a bar with a low that is lower than the price bars on either side of it as shown in Figure 2. This is also a swing low or a trough.
FIG. 1: Swing Highs
FIG. 2: Swing Lows
In some instances, a peak could be formed by four price bars rather than three with the two bars in the middle having the same high and the two outer bars having lower highs. In candlestick analysis, the two middle candlesticks would form a Tweezer Top pattern, here the last of the two ‘tweezer’ bars become the swing point. Inversely, a trough in a downtrend can also consist of Tweezer Bottom pattern where the two low bars have the same low and the two bars on either side of them having a higher low. Here again the last, or the right-most bar becomes the swing point. In rare occasions, the swing point can consist of three or more bars with the same high forming the peak, or three or more bars with the same low forming the through. In these cases, the last, or the right-most bar becomes the swing point.
A trendline is then drawn by connecting the swing points formed by the swing highs or swing lows. We need at least two swing highs or swing lows to draw a tentative trendline, and a third swing high or swing low to confirm the trendline. The more swing points that the trendline connects, the more valid the trendline becomes as the level of support or resistance becomes more significant.
Identifying the Major Swing Points
Drawing trendlines is not simply a matter of connection each and every swing point as not every swing point is equal. More than a century ago Charles Dow, the father of western technical analysis, alluded to the fractal nature of stock charts by suggesting that the market consists of three trends: the major trend, secondary or intermediate trends, and minor or short-term trends. As we have learned, the major trend consists of intermediate trends, while intermediate trends consist of minor trends. The intermediate trends and the minor trends also leave intermediate and minor swing points. Therefore, the literature always talks of using major swing points, i.e., the major highs or the major lows, to draw trendlines. But how do we identify these major swing points?
We can identify major highs and major lows by zooming out on our chart. We can zoom out on our chart to show 300 bars of price data and then look at the swing highs or swing lows that jump out at us – the ones that are stand out and are clearly significant. It can still take some time and experience to identify these major swing points so be patient and practice as often as possible.
Another method of zooming out on our chart is to change the time frame. It is often said that a trend on a larger time frame chart is more significant than one on a shorter time frame. This is because the 300 bars on the 15-minute chart is collapsed to 75 bars on the hourly chart, which also makes identifying significant swing highs and swing lows easier. By increasing the time frame, we have not simply reduced the price data; we have reduced the "noise" on the chart, i.e., we have reduced some of the intermediate and minor swing points. It is now easier to identify the major swing points and we can now transfer these swing points to the 15-minute chart and use these points to redraw the trendlines. This is also the basis for multiple time frame trading strategies.
FIG. 3: Swing Points
We can also use what Thomas DeMark refers to as swing points of greater magnitude in his book, The New Science of Technical Analysis. DeMark suggests that instead of identifying swing points that have a lower high on either side of it, in the case of a peak, or a higher low on either side, in the case of a trough, we identify a peak where the two candlesticks or bars that precede it have a lower low as well as the two candlestick or bars that follow it. In other words, we are looking for a peak where the center bar is the highest of five consecutive bars as shown in Figure 3. Similarly for a trough we could identify a trough where the center candlestick or bar is the lowest of five bars. These peaks and trough are of a greater magnitude than a peak or trough that consists of only three bars. A peak where the center bar is the highest of seven consecutive bars, i.e., where the center bar is preceded by three bars that have lower highs and is followed by three bars that have lower highs, would be of an even greater magnitude. Similarly for a trough that is flanked on either side by three higher lows. These peaks and trough are of a greater magnitude than a peak or trough that consists of only five bars.
Swing Point Spacing
Having identified our swing points, we now need to consider the spacing between them. Are swing points that are close together more relevant than swing points that are further apart? The answer is that, ideally, swing points should not be too close together and they shouldn't be too far apart. The difficulty is determining what is too close and what is too far apart as this would be dependent on the time frame and is a subjective measure. The important consideration occurs when selecting the first two swing points for the trendline. When these are close together and the third swing point that confirms the trendline is quite far, the trendline may be less reliable. If the third swing point is also close, the trendline would be more reliable, but might not produce large price movements. In other words, we would ideally like swing points that are roughly evenly spaced but with enough space between then to produce larger price movements. This ideal trendline does not always form in live markets. Therefore, trendline that are not ideal should not be discarded out of hand.
Trendline Angle
Another consideration is the angle or slope of the trendline that is produced when connecting the swing points. The angle of a trendline indicates the strength of the trend. When the trendline is too steep, there is less time for support and resistance to develop as the price action approaches the trendline. The result is a trendline could easily be broken when volatility disrupts the trend. A steep trendline would be one that the steeper than 45°. A shallow trendline that is less than 30° can be equally undesirable. A shallow trendline is an indication of a weak trend, with little potential for significant price movements. Thus, a trendline with an angle of between 30° and 45° would be more desirable. However, the angle of the trendline can be affected by the number of price bars shown on the chart and the spacing of the intervals on the Y-axis that shows the price. A chart with a compact X-axis that plots the time intervals or a chart with an extended or elongated Y-axis that plots the price intervals would lead to a trendline that appears steeper than it is.
Internal and External Trendlines
Thus far we have been discussing trendlines that connect swing highs and swing lows. These are called External Trendlines. But what happens when the swing points do not line up perfectly? Can one or two bars protrude below or above the trendline? This does happen at times when the market over-reacts, producing price spikes that penetrate the trendline without closing on the other side of the trendline. In these situations, drawing a trendline that cuts though the price spikes is acceptable. The goal is to get as many reasonably spaced touches within reason. Trendlines that cut though the price spikes are called Internal Trendlines.
Conclusion
We can now better identify the major swing points to use for drawing trendlines. These can be identified by zooming out on our chart to include more price data, shifting to a higher time frame, or identifying swing points of a higher magnitude. We have also learned that the spacing of swing points and the angle of trendline are important considerations. Ideally, swing points should be evenly spaced but not too close while the angle should not be too steep but should not be too shallow either. However, the most important aspect of a trendline is the number of swing points that it touches.
We have also learned that a trendline that connects two swing points is a tentative trendline. We need a third touch to confirm the trendline. This is an important point to remember. Only if the third touch holds is the trendline valid and can be used as a basis for trading. In other words, do not trade off a tentative trendline!
In the next lesson we will look at when and how to adjust a trendline.