What are trend lines?

In the previous blogposts, we studied the different types of markets. We have learned about the ranging markets and trending markets.

In this blog post, we will discuss trendlines, what it is, why it is a significant tool in forex trading and how to draw a trendline.

The trendline is used by many traders to find the direction of the trend, but that’s not the only use of the trendline. The trendline can be used for various purposes in forex trading. Some traders use it for plotting verticle support, and some use a couple of trendlines to form a pattern that gives them suitable entry points to get in a trade.

The trendline is the most commonly used tool in trading, let it be forex trading or stock trading, a trendline is a tool that almost every trader uses or has used in his trading career. A swing trader or day trader needs to be able to draw a trendline with accuracy, but what’s most important is to understand the psychology behind the trendline. We feel if you know the concept of anything, then it becomes much easier for you to use it.

So, let us first try to understand what is a trendline and what is the exact concept behind it, and then we will tell you how to draw a trendline accurately.

What is a trendline?

A trendline is a tool used by traders to find out the direction of the price. You must be knowing that there are different types of markets in forex — for example, up-trending market and down-trending market. So, to easily find out the direction of the market, traders use a trendline. There are two types of trendlines based on the direction.

1. Upward trendline (ascending)

The trendline which has an upward slope is called an upward trendline. The upward trendlines represent an up-trending market and tell us that the buyers are controlling the market.

2. Downward trendline (descending)

The trendline which has a downward slope is called a downward trendline. The downward trendline represents a down-trending market. This also tells us that the momentum of the market is with the sellers.

How are trendlines formed?

A trendline is a line drawn by connecting the swing highs or the swing lows to find the exact direction of the trend.

Consider the price is in an up-trending market, so this means that the buyers are in control of the market, and they are causing the price to move up. Now, while the price is moving up, sooner or later, a point will come where few buyers will take profit and get out of the trade and new sellers will enter? Consider this point at which the buyers take profit as your higher high.

Now as some buyers got out of the trade and some sellers came in, it will create a counterpressure and hence will cause the price to retrace and therefore will create a new higher low. After this retracement, if the price continues to move back up, this means that there still aren’t enough sellers to take away the momentum from the buyers and so it will move past the previous higher high and hence create a new higher high. Again some buyers will take profit and cause the price to retrace creating a new higher low.

So, now in an up-trending market when you connect these swing low and higher lows through a line, then it forms a trendline. The trendline formed here acts as verticle support for the price, and the buyers have a strong belief that the price is going to reverse from this line, so anytime it touches the trendline new buyers adds up, and the price bounces back up. So, this was the main psychology behind the formation and significance of the trendline.

How and why does a trendline break and what happens after the trendline breaks?

Now, if this trendline was acting as strong vertical support for the buyers, then why did the price broke through the trendline? It happens because the gap between the buyers and sellers gets covered as many sellers get into the trade; this causes the momentum to shift from buyers to sellers.

When the price breaks the trendline, it signals the momentum change and massive shift in the balance of the parties controlling the market. Therefore when the price breaks a trendline, it continues to move in the direction in which it broke the trendline.

Let us try to understand this more correctly. Let us consider that the price is in an up-trending market, which means that the buyers are controlling the market.

As you can see in the chart above, the buyers were in control of the market, and so the price was creating continuous higher highs and higher lows. So, when the price was creating continuos higher highs and higher lows, it was indicating to us that the buyers are totally in control of the market. Now, as you see in the chart the price after creating the last higher high gave a retracement, and after retracing it couldn’t create a new higher high indicating the selling pressure at the point.

So, what happened at this stage is, the price couldn’t create any new higher high and so sellers took it as an opportunity and got in the trade. This causes the momentum to change towards the sellers, and hence the price dropped down. Now, when the price dropped toward the trendline, few buyers entered the trade. But the momentum was still with the sellers as the sellers were more than buyers and hence it broke the trendline.

In the above chart, you can see the price started falling badly after the trendline break, and this happened because there were very fewer buyers left and they couldn’t push the price back higher. So, this how the trendline breaks, and this is the reason why the price keeps on moving in the direction in which it broke the trendline.

How to draw a trendline?

Drawing trendlines is an effortless task to do. Depending upon the type of market, you can draw trendlines by connecting the swing points properly. Here is how to draw trend lines.

1. Trendline for the up-trending market (ascending)

1. The trendline drawn in an up-trending market is an ascending trendline.

2. For the up-trending market, the trend line is drawn below the price.

3. The trendline is drawn by connecting all the higher lows in an up-trending market.

4. For a trendline to be valid, you need at least two touch confirmations.

5. To draw trendline accurately, make sure you also cover the wick of the candle.

2. Trendline for the down-trending market (descending)

1. The trendline drawn in a down-trending market is a descending trendline.

2. For the down-trending market, the trend line is drawn above the price.

3. The trendline is drawn by connecting all the Lower highs in a down-trending market.

4. For a trendline to be valid, you need at least two touch confirmations.

5. To draw trendline accurately, make sure you also cover the wick of the candle.

How to identify fake breakouts of the trendline?

If you are a trendline trader, then fake breakouts must be very annoying to you. Many a time it happens with every trader, you are able to find out a nice trendline entry, and so you enter into a trade. But even after drawing the trendline correctly and doing your analysis right, you end up losing that trade due to a fake breakout of the trendline. There are two ways by which I find out the fake breakouts and often save myself from losing a trade.

Based on what your entry style is, we can avoid getting stopped by a fake breakout. First, let us understand the cause of the fake breakout. According to our experience, there are two main causes for the fakeouts of the trendline

1. No proper shift of the momentum between the two parties

What we mean by this is that no genuine momentum shift is observed between the buyers and the sellers.

Let us try to understand this with the help of an example. Consider a price chart where the price broke the trendline but still got back into the trendline.

Now, as the price break the trendline the price should have dropped, but instead, it came back in. This happened because when the momentum shifted towards the sellers, they broke the trendline and maintained selling pressure but when the price broke the trendline there was an important support area which was a significant level for the buyers to enter and hence many buyers jumped back in causing the price to move back up. So, when the buyers entered the market, they took back the momentum of the market from the sellers and hence caused the price to move up.

2. Timeframe

If you are a breakout trader and you wait for the breakout of the trendline before entering a trade here is an important tip for you to follow, and this will save you a lot of money from the fake breakouts. Whenever you look for a breakout of the trendline always make sure the price broke the trendline on the highest possible timeframe.

Consider, you drew a trendline on the 1-hour chart, and you are waiting for the breakout of the trendline on the 1-hour chart to get into a position.

Now, the price broke the trendline on the 1-hour chart, and you entered a trade. So, after breaking the trendline the price should go in the direction in which it broke the trendline, yet it comes back inside the trendline. This happens because the trendline which you draw on the 1-hour chart is also valid on the 4-hour chart or any higher timeframe. So, for a successful breakout of the trendline, the price should break the trendline on the highest possible timeframe, or the highest timeframe on which the trendline is valid. And only when the price does this, you can count it as a successful breakout of a trendline.

Trendline trading strategies

In forex trading, you can’t rely on any single trading setup. Even if you are an expert in drawing and understanding trendlines, there are other few setups which when combined with trendlines can give an exceptional result.

1. Trendline support and resistance strategy

Trendline and support and resistance are two of the most important topic of forex trading. When both are combined to form a strategy, you can get exceptional results in your trading. You can trade using this strategy in two ways, and I will be explaining to you how to that.

You must have heard that you can possibly trade trendline using the touchpoints you get on the trendlines, and these entries are called continuation entries. Trading trendlines in such a way is easy but many times can make you lose money, so I recommend you to use support and resistance in these continuation entries so that you can get an extra confirmation on the trade you are about to enter.

Let us understand how to use support and resistance with trendlines to get an exact continuation entry.

In the chart above you can see that the price was up-trending and respecting a trendline. The price gave more than two touches on a trendline to confirm that trendline. The price further moved upward and broke the resistance level, which I have marked in the chart. Now, the resistance which the price broke is acting as a support, and we also have our trendline touch which confirms a nice continuation entry with a tight stop loss and will also provide a high risk to reward ratio.

So, this is how you can use support and resistance levels with trendlines to get nice continuation entries with a high risk to reward ratio.

2. Trendline reversal strategy

If you are a trendline breakout trader, then this can be a very useful trading strategy for you. What if you knew exactly when the trendline is about to break? You can analyze if a trendline is going to break if you use it to support and resistance levels.

Let us try us understand this with the help of an example,

In the chart above, you can see the price was up-trending and respecting an ascending trendline. Now when the price was moving up, it reached a resistance level, and then it dropped from there. So, you can enter a sell trade at this resistance level, which will be a risky entry but will give you a nice risk to reward ratio. In this trade, you can keep the stop loss a few pips above the resistance level.

For a safe entry, you can wait for the price to break the trendline, and then you can enter a sell trade after the price breaks the trendline. In this entry, you can keep the stop loss above the resistance level or close the trade manually if the price gets back into the trendline. This may not give you a tight stop loss but will provide you with a safe entry point.

This blog originally published on my blog