Look at the chart display. What is the trend for prices? Quite clearly they are going down. If we already have purchased this counter at $7.50, we should be worried. If we are potential buyers of this counter then the price move or break above $6.70 gives us a reason to buy the stock. The trend line gives us a way to decide which price action is significant, but only if it is accurately drawn.
We use a straight edge trend line to tell us which direction prices are moving and to give us a better way to judge the trend. If prices close under the up trend line then it suggests the stock price is falling. Ideally we would want to get out to this stock, selling it to collect our profits and to protect ourselves against loss. We get this exit signal when there is a close, or a series of closes, below the trend line.
In a downtrend, the line is placed along the price highs. A close above this line tells traders the trend may be about to change direction. This is used as an entry signal. Where we draw the trend line is important because it could cost us money.
When we think about buying a stock many traders try to buy a trend breakout. This is when a downtrend turns to an uptrend and prices ‘break out’ above the trend line. Traders try to buy the stock near the bottom just as the stock price starts to move up. They get a buy signal when the price closes above the downtrend line.
Up trend or down trend, the principles of drawing the trend line are the same. An accurate trend line uses the information available from a bar or candlestick chart. Good trend lines need to use the high or the low prices for accuracy. They are not easy to plot accurately to a line chart.
These are the construction rules:
1) The line is placed along the lows of the price bars or candlesticks in a rising trend. An up trend is defined by higher lows each day. This is the price element we want to track, so the line goes underneath. If prices fall below this line then the trend may change into a downtrend.
A falling trend is defined by the failure of prices to make new highs each day. We track this by placing the downtrend line along the highs as shown in the chart.
2) The trend line uses the extremes of the price bars or candle sticks. This is the high or the low price. These extremes are important because a close beyond the extreme tells traders the trend might be changing. This is an entry, or an exit, signal.
3)The trend line starts at the very extreme high, or low. This is called a pivot point.
4) The trend line should touch the maximum number of possible price bar or candlestick extremities. This means we do not exclude too many, nor do we go for the maximum number of hits. We want to use the trend line as a trading signal, so we are interested in closes beyond the extremes of the existing trend because these give the best trading signals
5) The more often a trend line is hit by price extremes, but not broken, the more powerful the trend line signal. A trend line that has been hit 5 times, but not broken, is very strong. So when prices do close beyond the trend line it is a very strong signal that the trend is changing.
On the chart trend line 1 is a correctly drawn trend line. It touches the optimum number of price extremes. Trend line 2 shows the general direction of prices. Trend line 2 does not give any useful trading signals and prices move above and below this line all the time. Trend line 1 shows us when the downtrend has finished. The close above t trend line 1 clearly signals the beginning of a new up trend and provides an entry signal.
Straight edge trend lines are a very powerful trading signals, but they must be placed correctly. They are used to show the short term trend - perhaps days or weeks - the intermediate term trend - perhaps weeks or months - and the long term trend - perhaps months or even years. Long term trends are best seen on a weekly bar or candlestick chart.
Not all trends are easily defined with a straight edge trend line.
