What Are Trend Lines?
Basics
Trend lines are a common tool in financial markets for visualizing price movements and identifying trends. These lines are diagonal and connect specific data points on charts. Chartists and traders use trend lines to help them analyze market trends.
Trend lines are considered one of the most basic tools in technical analysis. They are widely used in various markets, including stocks, fiat currency, derivatives, and cryptocurrencies. Trend lines work similarly to support and resistance levels but are made of diagonals instead of horizontal lines. They can have either a positive or negative slope, with a greater slope indicating a stronger trend.
There are two basic types of trend lines: ascending (uptrend) and descending (downtrend). An uptrend line is drawn from a lower to a higher chart position, connecting two or more low points. Conversely, a downtrend line is drawn from a higher to a lower position in the chart, connecting two or more high points. The difference between the two types of lines is the selection of the points used to draw them. Uptrend lines are drawn using the lowest points in the chart, while downtrend lines are drawn using the highest values. For example, uptrend lines are formed by connecting candlestick bottoms that form higher lows, while downtrend lines are formed by connecting candlestick tops that form lower highs.
Utilizing Trend Lines
To use trend lines, traders need to examine the highs and lows of a chart to determine where the price tested the prevailing trend before turning in its favor. This line can then be extended to predict future important levels. As long as the trend line is not broken, it is considered valid, even if it is tested several times.
Trend lines are commonly used in financial charts to provide insights into market supply and demand. Upward trend lines indicate an increasing buying force, while downward trend lines suggest supply is higher than demand, resulting in consistent price drops.
Trading volume must also be considered when analyzing trends. If the price is increasing, but the volume is decreasing or relatively low, it may give a false impression of increased demand.
Trend lines help identify support and resistance levels, which are essential concepts in technical analysis. An uptrend line shows support levels below which the price is unlikely to drop, while a downtrend line highlights resistance levels above which the price is unlikely to rise. When these key levels fail to hold the trend, the market tends to change direction, invalidating the trend.
Technical analysis is subjective, and people may use different methods for drawing trend lines. Important to note, Combining multiple TA techniques and fundamental analysis can reduce risks.
Drawing Valid Trend Lines
Chartists usually require a minimum of three points to draw a valid trend line. Although it is technically possible to connect any two points, using three or more is recommended to determine its validity. Sometimes, the first two points are used to define a potential trend, while the third point (extended in the future) is used to test its validity.
The trend can be considered valid if the price touches the trend line three or more times without breaking it. This is because the trend has been tested multiple times and suggests that it is not just a coincidence caused by price fluctuations.
Importance of Scale Settings in Trend Line Drawing
When drawing trend lines on financial charts, it's essential to consider proper settings. One of the most important chart settings is the scale, which refers to how the price change is displayed.
There are two popular scales: arithmetic and semi-logarithmic (semi-log). An arithmetic chart expresses the price change evenly as the price moves up or down the Y-axis. In contrast, semi-log charts represent variations in percentage.
For example, a $5 to $10 price change would cover the same distance as a $120 to $125 change on an arithmetic chart. However, on a semi-log chart, the $5 to $10 change would occupy a much larger portion than the $120 to $125 increase.
It's crucial to consider the scale settings when drawing trend lines, as each type of chart may result in slightly different trend lines based on their highs and lows. Choosing the appropriate scale and applying it correctly ensures that the trend line accurately represents the data.
Conclusion
While trend lines are valuable tools for technical analysis, they are not entirely reliable due to their subjectivity. Depending on which points are selected to draw the trend lines, they can have different degrees of accuracy and represent market cycles and actual trends differently.
Some chartists may choose to draw trend lines based on the body of the candlesticks, while others may prefer to include the highs and lows of the wicks. Therefore, it's essential to use trend lines in conjunction with other charting tools and indicators, such as the Bollinger Bands (BB), Ichimoku Clouds, MACD, RSI, Stochastic RSI, and moving averages.