Trading 101: Trendlines
Since we discovered in our previous post what trends are, it is time to start with trend analysis. The most common method to analyze trends is drawing trendlines. Technical analysts widely use trendlines as an indicator to confirm existing trends or to identify the end of a price trend. It’s one of the essential tools in the repertoire of every trader and analyst.
Excursion: Support and Resistance
Before we get into detail about analyzing trendlines, we need to get a basic understanding of supports and resistances. Usually, trendlines will act as such. Remember that supply and demand drive the markets. A point of support is where the demand (buyers) is strong enough to stop the price from further decline. Vice versa, resistance is a point where the supply (sellers) is strong enough to keep the price from rising.
The chart above illustrates this beautifully. The price ranges between resistance and support, touching each side several times. That is until the market seemingly gave in and a fake-out above the resistance point occurred. A fake out is a short rise of the price above the resistance- or the below support level. The fake-out caused the selling side to react with a strong reaction, as they pushed the price below the support level. Just as the price moved back into the demand and supply equilibrium, it ultimately broke down below the support point. This chart is an excellent example of the battle between buyers and sellers, or demand and supply.
The easiest way to analyze trends is by using trendlines. A trendline is a straight line connecting two or more price points. Usually, it connects the highs or lows of the price. As a rule of thumb remember two price touches make the trend line, the third one makes it valid.
A downtrend is defined by several lower lows and lower highs following each other over an extended period. The blue line shows our original three touches of the trendline. The black part of the trendline, would have been projected into the future. As the price continues to decline, the trendline serves as strong resistance for the price. The validity of the trendline increases with every further price touch. At the bottom of the chart, the momentum of the downtrend starts to fade. The price ends up consolidating in the area of the last lower low. Ultimately, the trendline gets broken upwards, signalling a possible trend reversal.
The uptrend works in the exact opposite way a downtrend does. As a consecutive series of higher highs and higher lows follow each other. Again, the blue line signals our three original touches of the trendline. The black part of the trendline is projected into the future.
Just as the trendline acted as resistance in a downtrend, it works as support-level in the uptrend. Strong demand decoupled the price from the trendline in the middle of the chart. Keep in mind that prices often will return to the trendline level after doing so. Even when your trendline is not attached to the price anymore, you should keep it on the chart for future analysis. As the price further declines, it peaks and finds a sharp retracement back to the trendline, creating a lower low. While the price respects the trendline as a support level for a short while, it breaks downwards soon after.
When the market is unable to decide on the direction of the market, the trend goes ‘sideways’. As the market doesn’t go sideways in a straight line, it will continue to make waves of highs and lows. The up- and downwards waves tend to end in the same price areas, creating a ‘range’ of price movement. Neither supply nor demand is strong enough to push the price out of that range. The buyers and sellers continue to battle it out within the price range.
The highs and lows build the range of the battleground. Think about it like trenches in the first world war. The buyers push forward a few feet on one day, and the sellers will push them a few feet back the next day. Consequently, a support and resistance zone builds as the floor and ceiling of this battlefield, which will exist until one side is strong enough to overpower the other.
Support - Resistance Flip
As we determined, trendlines serve as support and resistance levels in up- and downtrends. A broken uptrend line can become a resistance level for the following uptrend and vice versa in a downtrend. Therefore it is always viable to keep a broken trendline active on your chart for a while.
Trendlines are one of the most disputed and discussed topics in technical analysis. Some call them subjective and artistic, as placement is not a fixed variable but up to the personal choice of the analyst. Others try to sell their methods of trendline placement as the supposedly only correct way. Let’s take a look at a few of those disputed aspects.
Distance of touches
Generally, the touches of the trendline shouldn’t be right next to each other. At the same time, the first and second touch shouldn’t be across the whole chart either. A trendline shouldn’t become long because of the initial price contacts. It should increase in length because it adds more touches along the way. However, there are no real sound rules for this anywhere in the specialized trading literature. Exercise will give you the right feeling at drawing appropriate trendlines.
Semi log- or regular chart scale is a whole topic for itself. In the matter of trendline drawing the log-scale can be a useful tool. The log-scale holds trendlines better in line with the price movements during a more extended period.
Both charts above cover the same timeframe. The trendline drawn on the semi-log scale chart keeps better in line with the price and continues to serve as a viable signal. The regular trendlines decouple from the price and produce only weak signals. As a rule of thumb, it’s advisable to check the semi-log chart once the price decoupled from the trendline on the regular scale chart.
Usually, analysts draw a trendline by connecting the highs or lows of a candle. This could lead to the assumption that trendlines are broken whenever the next wick of a candle goes through it. However, trendlines will often keep intact after being violated by a wick. A more evident violation of the trendline would be the price closing outside of the trendline. Remember, cryptocurrencies are highly volatile markets and you need to adjust your rules to it.
A way to counter this is by connecting the trendlines with the open and close prices instead of the highs and lows. This method is supposed to cancel out the noise of volatility and over-reactions of the market. However, as the price range is a lot more compressed, internal trendlines have the downside of breaking a lot earlier and being prone to deliver false signals.
Let me make a little stretch here. Some of you that are on the discord might know that I studied medicine next to my trading activities. In medicine we have a famous proverb by the ancient Greek physician of Hippocrates: “He who heals is right”.
It’s no different with trendlines: Whatever works for you works! There is no scientific ‘correct’ way how to draw trendlines. You need to find the approach that works best for your style of trading and be consistent with it. Many traders tend to change around the rules of their trendlines until it fits their bias. Take the approach that feels most reasonable to you. Test your trendlines systematically and only turn things around when you identified what is not working right. Whatever method you end up using to draw your trendlines, you need to stay consistent and stick with it.