What is a trendline? How do technical analysts use trendlines? How are up and down trendlines created? How do you know when a trendline is dependable? Are there different types of trends? How do you play the trend? How do you know when a trendline is broken?

What is a trendline?

According to Schabacker, "a trendline is a straight line drawn on a chart through or across the significant limits of any price range to define the trend of market movement." ¹⁵

Trendlines were one of the first technical aspects of the market to be discovered. Technical analysis is based on the fact that the prices of stocks move in fairly definite trends. Prices trend for individual stocks and for the market as a whole. Technical analysts use trendlines in two ways: first, to identify the direction of the movement of stock prices; second, to determine if and when the movement will change.

How do technical analysts use trendlines?

Stock prices move in trends. Once a trend has been clearly identified, it's likely to continue for a time. Technical analysts look to trendlines for their ability to support price declines or resist price advances. ¹⁶

When prices are moving neither up nor down, trendlines have little importance. Technical analysts looking for a profitable trendline will search for ones that slope up or down across the charts. These illustrate stock prices that are clearly trending either up (as illustrated by an "up trendline") or down (as illustrated by a "down trendline").
A trendline not only shows the trend but it also defines the limits of price swings of the stock. Assume a stock's price is trending upwards. If the stock's price dips significantly below its trendline, it may mark a reversal - the end of the trend.

No trend continues forever. Technical analysts are as concerned with the breaking of trendlines as they are with watching a trend continue.

How are up and down trendlines created?

An up trendline marks the upward progression of a stock's price. The line is drawn on the chart by connecting the low points the stock hits as its price continues to rise. Each low point will be successively higher than the previous low. This progression gives the trendline its upward slope.
A down trendline marks the downward progression in the price of a stock. It is formed by drawing a line on the chart connecting the high points the stock hits as it continues to fall. Each high point will be successively lower than the previous high. This progression gives the trendline its downward slope.

How do you know when a trendline is dependable?

It's not easy to determine whether or not a trendline is valid. Experience and common sense are two vital skills to possess. According to Schabacker, "no one can take a chart, immediately draw trendlines on it and be certain that they are the proper, or even the best, trendlines that could have been inserted for continuation of the current movement. That is just as impossible as is the absolutely certain forecast of definite future prices by any finite individual." ¹⁷

Cautious investors look for more than two points on the chart which touch the trendline. They'll be watching for a third and fourth point which confirm the trendline they've identified. In addition, experts advise watching for points on the trendline (highs for a down trendline, lows for an up trendline) that are fairly evenly spaced along the chart.

A common mistake is to draw a trendline that is too steep. Often a major movement in the market - which begins very steeply on a chart - will look like it's starting a trend. Many trendlines level off significantly after an initial burst of activity. This is where the experience of drawing and redrawing trendlines can pay off for the investor.

When drawing and redrawing trendlines on a chart, the investor can end up with a chart where the trendlines, which start out steeply, become ever shallower. These "trend reduction lines," drawn from the same starting high or low, create a fan pattern on the chart, giving them the name of "fan lines." According to Kahn, fan lines are, by definition, congestion zones as buyers and sellers position themselves. ¹⁸

Are there different types of trends?

Edwards and Magee divide trends into three basic varieties:
1. Major or primary trends - a trend of at least one year's duration which shows a rise or decline of at least 20%. When the primary trend is up, this is called a bull market. When it's down, it's referred to as a bear market.
2. Minor trends - brief fluctuations (usually less than six days and rarely longer than three weeks). Taken together these short-term fluctuations make up an intermediate trend. Experts will often define an intermediate market as composed of three or more minor fluctuations.
3. Intermediate or secondary trends - these trends move in the opposite direction of the primary trend and usually last for three weeks or more. For example, a secondary trend could be an intermediate decline during a bull market or an intermediate rally or recovery during a bear market. These secondary trends tend to retrace from one-third to two-thirds of the gain or loss in prices recorded in the primary direction.

How do you play the trend?

According to Achelis, "the goal is to analyse the current trend using trendlines and then either invest with the current trend until the trendline is broken, or wait for the trendline to be broken and then invest with the new (opposite) trend." ¹⁹

An investor should not rely on a trendline alone to make a trading decision. Trendlines are one tool that should be used in combination with other signals, including reversal and continuation patterns, which form over time.

All trading decisions are highly dependent on the type of trend being followed. Schabacker advises that it is much safer and much more profitable to play the intermediate movements that run in the direction of the basic major trend, rather than the minor corrections that run counter to it.²⁰ According to the trader's axiom, the trend is your friend.

Many traders advise that primary trendlines serve the useful purpose of preventing investors from taking profits prematurely. In other words, the trendline tells investors to stay "long" if the trend is up, or "short" if the trend is down.

Keep an eye on fan lines. They can provide a sign of a reversal, signalling the end of a trend. Many analysts suggest that a reversal may occur when the third trendline is touched. According to Kahn, if that third trendline successfully supports or resists prices, then the original trend is still intact. Like any technical pattern, investors should hold their trading until the pattern is clearly and unequivocally resolved. ²¹

Patterns help greatly in interpreting trend lines. The formation of a pattern can have great significance in determining whether a trendline is broken. This serves as an important reminder to the investor to use all of the technical tools available and not to rely on any one single tool.

How do you know when a trendline is broken?

Schabacker warns investors to be more conservative with longer trendlines. The longer the trendline, the greater the possibility that its angle may be slightly off. This means that any price that appears to have broken the "slightly off" line may, in fact, not have broken the true trendline. "Consequently, the longer our line has run from its origin the more critical we must be of any price action which apparently breaks the line, and the more conservative in taking action on it." ²²

There are several factors to consider in determining whether a trendline is definitively broken:
1. Volume - In some cases, penetration will be accompanied by increased trading in the stock.
2. Significant price movement - A slight correction in price is seldom a signal of a true break in an intermediate or major trend.
3. Closing price - Analysts will usually ignore breaks in the trendline which occur during the trading day, focussing instead on the closing price for the day.
4. Presence of a pattern - Analysts like to see a pattern formation at the end of a major or intermediate trend. A pattern signalling a reversal reinforces the importance of the break in the trendline

¹⁵Schabacker, p. 265
¹⁶Schabacker, p. 265
¹⁷Schabacker, p. 269
¹⁸Kahn, p. 42
¹⁹Achelis, p. 287
²⁰Schabacker, p. 279
²¹Kahn, p. 42
²²Schabacker, p. 284