The Importance of Trend & Tend Lines

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Why is Trend Important?

We've talked about trend in this module already, under Dow Theory - The Basic Assumptions and found that there are primary, secondary & minor trends and a trend has 3 phases (accumulation, public & excess in an up trend and distribution, public & panic in a down trend). We've seen that trend doesn't always go in a straight line as it tends to zigzag and we've also defined trend as - an up trend makes higher highs and higher lows and a down trend makes lower highs and lower lows. 

This is important because traders must be able to understand and identify trends to trade with the trend, rather than against it. Two important sayings in technical analysis are "the trend is your friend" and "don't buck the trend," illustrating how important trend analysis is for technical traders.  In essence Technical Analysis is built on the assumption that prices trend.

However, It can be hard to identify trends so revisit Peak and Trough Analysis, or Using The MACD to Identify Trend Lines in Mod4 if you are still unsure.  Also, to get  a clearer picture of trends in different time frames you must also study Multi-timeframe analysis.  The most important things to take away from this section are
  1. Is there a trend
  2. What is the direction
  3. What is it's length
From these 3 points further technical analysis is needed to enter and exit trades.

There are two trends - up and down.  But what about a sideways trend?  Well, technically this is a lack of trend and may be a consolidation period, or a period of indecision.  It's identified by peaks and troughs not making consecutive higher highs and higher lows or lower highs and lower lows.  

Charting the Trend - Trend Lines and Channels

Trend lines
Most charting packages will allow traders to draw trend lines and channels.  These two charting techniques make it easy for traders to visually see the trend and how the market is trading along the trend.  In the below chart of Coca Cola we have an up trend and a trend line has been drawn meeting all the major troughs in a 14 month period.  Many of the principles applicable to support and resistance levels can be applied to trend lines as well.  This trend line has now become a support line for the price of Coca Cola ( see Support and Resistance and Why They Matter).  

It takes two or more points to draw a trend line. The more points used to draw the trend line, the more valid a trend line will be. It can sometimes be difficult to find more than 2 points from which to construct a trend line. Even though trend lines are an important aspect of technical analysis, but it's not always possible to draw trend lines on every price chart. Sometimes the lows or highs just don't match up, and it is best not to force the issue. The general rule in technical analysis is that it takes two points to draw a trend line and the third point confirms the validity.

Example of a Up Trend Line

Trend lines can be drawn in an up trend or down trend. A down trend line has a negative slope and is formed by connecting two or more high points (Down trend lines are drawn above price). We can see an example of this in our below EUR/USD chart.  The second high must be lower than the first for the line to have a negative slope. Down trend lines act as resistance, and indicates that net-supply (supply less demand) is increasing even as the price declines. A declining price combined with increasing supply is very bearish, and shows the strong resolve of the sellers.

Example of a Down Trend Line

Channels
Similarly we can draw a channel to charts.  A channel is two parallel lines touching both peaks and troughs of a trend.  In the below chart of Applied Materials we've drawn a channel touching the very top peaks and bottom troughs.  The addition to the two channel lines allows traders to view quite clearly where support and resistance are.  Support being the bottom of the channel and resistance being the top.  Traders will now expect this security to trade within this channel and when the price breaks from the channel a substantial move may take place.  As with trendline, channels can be drawn in an up trend or down trend.  They can also be drawn in a horizontal move sideways and again the more points touched the more valid the channel is.

Example of a Channel

Validating Trend Lines and Channels
It takes 2 or more points to draw a trend line or channel and if you can find a third then the trend line or channel becomes more valid.  If you find it hard to match up points then don't force the issue and don't go looking for patterns that just aren't there.  Saying this, sometimes market volatility will move peaks and troughs over trend lines and channels.  In our EUR/USD down trend example we can see Top 2 just overshooting our down trend line.  Traders should be reasonable about overshoots - if it looks wrong, it probably is.

A couple of more things to watch include spacing of peaks and troughs and the steepness of the trend.  Ideally the peaks and troughs should be evenly spaced.  If they're too far apart they may have lost their relationship with each another and if they are too close together then the validity is brought into question.  Secondly, if the trend looks steep then the validity may come into question as steep trends tend to be short term moves.  Short term price moves aren't valid support and resistance levels and any attempt to draw these lines may eventually result in losing money.  

Logarithmic versus Linear Charts when Forming Trend Lines
Some traders will use Log or semi-log charts when drawing their trend lines, especially when measured over a longer time period (See our section on Charting).  They tend to be useful because they more accurately reflect the stocks acceleration and deceleration as a percentage and take out the kinks sometimes found after wild price moves.  In the below example of Amazon we can see the semi-log versus the linear (or Arithmetical) charts when drawing trend lines.  The semi-log chart shows trend being broken in Nov 2001, while the linear shows trend being broken in Mar 2001.  In truth the linear trend line would have needed to be drawn twice to achieve the true downward trend line.   In the short term Linear charts will do however and perhaps it's prudent to use both in forming you trading decisions as trend lines will be seen in both under different circumstances.

Amazon - Log V Linear Charting for Trend Lines

Why are Channels and Trend Lines important?
Both of these examples of trend lines and channels show the psychological state of the market, where trading is trending within certain boundaries of supply and demand.  All parties are observing these support and resistance levels and will react strongly when there is a jolt taking price out with these boundaries ( see Support and Resistance and Why They Matter).  

In our Coca Cola up trend, even though there are rising prices we have rising net demand (demand minus supply).  Increasing demand on rising prices is a very bullish sign and shows great conviction by buyers.  As long as prices remain above the trend line, the uptrend is considered solid and intact. A break below the uptrend line indicates that net-demand has weakened and a change in trend could be imminent.  

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Why is Trend Important?

We've talked about trend in this module already, under Dow Theory - The Basic Assumptions and found that there are primary, secondary & minor trends and a trend has 3 phases (accumulation, public & excess in an up trend and distribution, public & panic in a down trend). We've seen that trend doesn't always go in a straight line as it tends to zigzag and we've also defined trend as - an up trend makes higher highs and higher lows and a down trend makes lower highs and lower lows. 

This is important because traders must be able to understand and identify trends to trade with the trend, rather than against it. Two important sayings in technical analysis are "the trend is your friend" and "don't buck the trend," illustrating how important trend analysis is for technical traders.  In essence Technical Analysis is built on the assumption that prices trend.

However, It can be hard to identify trends so revisit Peak and Trough Analysis, or Using The MACD to Identify Trend Lines in Mod4 if you are still unsure.  Also, to get  a clearer picture of trends in different time frames you must also study Multi-timeframe analysis.  The most important things to take away from this section are
  1. Is there a trend
  2. What is the direction
  3. What is it's length
From these 3 points further technical analysis is needed to enter and exit trades.

There are two trends - up and down.  But what about a sideways trend?  Well, technically this is a lack of trend and may be a consolidation period, or a period of indecision.  It's identified by peaks and troughs not making consecutive higher highs and higher lows or lower highs and lower lows.  

Charting the Trend - Trend Lines and Channels

Trend lines
Most charting packages will allow traders to draw trend lines and channels.  These two charting techniques make it easy for traders to visually see the trend and how the market is trading along the trend.  In the below chart of Coca Cola we have an up trend and a trend line has been drawn meeting all the major troughs in a 14 month period.  Many of the principles applicable to support and resistance levels can be applied to trend lines as well.  This trend line has now become a support line for the price of Coca Cola ( see Support and Resistance and Why They Matter).  

It takes two or more points to draw a trend line. The more points used to draw the trend line, the more valid a trend line will be. It can sometimes be difficult to find more than 2 points from which to construct a trend line. Even though trend lines are an important aspect of technical analysis, but it's not always possible to draw trend lines on every price chart. Sometimes the lows or highs just don't match up, and it is best not to force the issue. The general rule in technical analysis is that it takes two points to draw a trend line and the third point confirms the validity.

Example of a Up Trend Line

Trend lines can be drawn in an up trend or down trend. A down trend line has a negative slope and is formed by connecting two or more high points (Down trend lines are drawn above price). We can see an example of this in our below EUR/USD chart.  The second high must be lower than the first for the line to have a negative slope. Down trend lines act as resistance, and indicates that net-supply (supply less demand) is increasing even as the price declines. A declining price combined with increasing supply is very bearish, and shows the strong resolve of the sellers.

Example of a Down Trend Line

Channels
Similarly we can draw a channel to charts.  A channel is two parallel lines touching both peaks and troughs of a trend.  In the below chart of Applied Materials we've drawn a channel touching the very top peaks and bottom troughs.  The addition to the two channel lines allows traders to view quite clearly where support and resistance are.  Support being the bottom of the channel and resistance being the top.  Traders will now expect this security to trade within this channel and when the price breaks from the channel a substantial move may take place.  As with trendline, channels can be drawn in an up trend or down trend.  They can also be drawn in a horizontal move sideways and again the more points touched the more valid the channel is.

Example of a Channel

Validating Trend Lines and Channels
It takes 2 or more points to draw a trend line or channel and if you can find a third then the trend line or channel becomes more valid.  If you find it hard to match up points then don't force the issue and don't go looking for patterns that just aren't there.  Saying this, sometimes market volatility will move peaks and troughs over trend lines and channels.  In our EUR/USD down trend example we can see Top 2 just overshooting our down trend line.  Traders should be reasonable about overshoots - if it looks wrong, it probably is.

A couple of more things to watch include spacing of peaks and troughs and the steepness of the trend.  Ideally the peaks and troughs should be evenly spaced.  If they're too far apart they may have lost their relationship with each another and if they are too close together then the validity is brought into question.  Secondly, if the trend looks steep then the validity may come into question as steep trends tend to be short term moves.  Short term price moves aren't valid support and resistance levels and any attempt to draw these lines may eventually result in losing money.  

Logarithmic versus Linear Charts when Forming Trend Lines
Some traders will use Log or semi-log charts when drawing their trend lines, especially when measured over a longer time period (See our section on Charting).  They tend to be useful because they more accurately reflect the stocks acceleration and deceleration as a percentage and take out the kinks sometimes found after wild price moves.  In the below example of Amazon we can see the semi-log versus the linear (or Arithmetical) charts when drawing trend lines.  The semi-log chart shows trend being broken in Nov 2001, while the linear shows trend being broken in Mar 2001.  In truth the linear trend line would have needed to be drawn twice to achieve the true downward trend line.   In the short term Linear charts will do however and perhaps it's prudent to use both in forming you trading decisions as trend lines will be seen in both under different circumstances.

Amazon - Log V Linear Charting for Trend Lines

Why are Channels and Trend Lines important?
Both of these examples of trend lines and channels show the psychological state of the market, where trading is trending within certain boundaries of supply and demand.  All parties are observing these support and resistance levels and will react strongly when there is a jolt taking price out with these boundaries ( see Support and Resistance and Why They Matter).  

In our Coca Cola up trend, even though there are rising prices we have rising net demand (demand minus supply).  Increasing demand on rising prices is a very bullish sign and shows great conviction by buyers.  As long as prices remain above the trend line, the uptrend is considered solid and intact. A break below the uptrend line indicates that net-demand has weakened and a change in trend could be imminent.  

More...


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