As simple as trendlines are, they are one of the most helpful tools that you have.
In fact, they are overlooked by many investors because they appear to just have one or two basic rules. But I can go on for hours teaching students only about trendlines, the different variations, which ones are more potent than others, computer systems that use them to trade, what the implications are and so on.
I’ll give you the very shortened version today. Whether you understand trendlines or not, you should definitely pay attention here to trendline construction before I show you how to apply them to today’s market.
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The up trendline (blue) is drawn along successively higher lows. The down trendline (red) is drawn along successively lower highs.
For an up trendline to be drawn, you’ll obviously need at least two lows (one higher than the last) in order to have two points to connect. Below is a basic picture of a stock or index that had been moving lower, but then attempts to reverse back up.
Where would you start to draw the trendline in this example?
Well, don’t even bother drawing a trendline (when you see a situation like the one above) until the high that was just set (resistance) is penetrated the way it happened below. What you have below is a “tentative up trendline”.
The tentative trendline doesn’t become a confirmed trendline until the third low is set. Above you can see only two lows (one higher than the last) were set. So it hasn’t yet been confirmed. (Many people who think they understand trendlines don’t know this.)
Let’s look at the images below. The trendline is the straight diagonal white line.
In the uptrending stock on the left, the tentative trendline has developed only after a higher low is made (3), AND resistance (2) is penetrated.
When the “wave” below turns yellow, it indicates that we have a tentative trendline, and when the wave turns green on the third bounce (5), it indicates that we have a confirmed trendline.
The exact opposite is true for the down trendline. If a lower high is made (3), and then the first low, which is support (2), is penetrated, then you have yourself a tentative down trendline. (The yellow wave signifies when we have a tentative downtrend.) Once a third lower high is made (5), the trendline is considered confirmed.
You can use trendlines as a foundation for profitable technical analysis based decisions in pretty much any kind of security, whether it be stocks, bonds, futures, currencies or commodities.
The Subjective Nature of Trendlines
But one important thing to understand about trendlines is that they can be subjective.
Some people wouldn’t consider an up trendline to be violated (broken to the down side) or a down trendline to be penetrated (broken to the upside) unless the trendline was crossed (at the closing price) by at least 1%, or 1.5% depending on who you asked. Others are not as strict, and if a chart shows any closing price on the wrong side of the trendline, the position is exited.
Here’s another way they can be subjective. Let’s look at today’s general stock market by way of the S&P 500 (SPX) chart below.
You can see the market sold off from mid-January to early February. There was definitely a tentative down trendline in place.
NOTE: This is an intermediate trendline if you want to know the time frame. We have short-term trendlines (days to weeks), intermediate-term trendlines (weeks to months), and long-term trendlines (months to years).
Right when the moment of truth came for that down trendline, you can see instead of finding resistance, and then bouncing down off the black down trendline (which would have confirmed it), the down trendline was penetrated, voiding it out, and creating a potential trend reversal. Here’s where the subjective part comes in …
We clearly have two bounces. We have a higher low made after the first low (lower blue arrow). But was the second (higher) low made at the green arrow or the blue arrow?
There was certainly a small bounce after the first low (lower blue arrow). But was there enough of a bounce, at the green arrow, to call it a “bounce”?
Some would call the green arrow the next/higher low. And that would mean it became a tentative up trendline when the S&P 500 broke above 1,080, along with a confirmed up trendline after the second arrow bounce. Others are sitting here waiting to see if we get another bounce off of the (tentative?) up trendline before calling it a “confirmed” up trendline.
The best way to think about something like this is to not be robotic. Technical analysis is an art and not a science. We have so many other things going on right now that tell us demand is definitely in control of the market, albeit at relatively high levels. We’d have to be crazy to base our trades solely on a confirmed trendline.
So the way we play the market now is to be cautiously bullish (as opposed to defensive or bearish). Seeing a larger first bounce would just be one more thing to reinforce our bullish argument. But it is what it is.
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