Basics of Trendline

What makes this article different than others?

This isn't a standalone article but rather is a part of series of articles which I have written about Trendlines. I wouldn’t be mistaken if I say that Trendlines are the most used trading tool in technical analysis and how much you know about these trendlines alone can define how you perform as a Trader. A topic of this importance, and yet most authors try to explain this gem in a single article and by just explaining the basics.
This article is about basics so if you have already been in the market and have an idea how a trendline looks and performs, you can jump right to the next article in the series where I have defined the Essential features of Trendline. The link is at the bottom of the article. So, let’s now get going.

Before we understand trendlines, we need to understand 'Swing Highs' and 'Swing Lows' or 'Peaks' and 'Valleys', as they are otherwise known. Price doesn’t move in a straight line in any direction. It moves in the form of Waves, and in that process, the price makes these highs and lows. See the chart below:

Every trader must know the importance of these highs and lows well, as they are the fundamental of price analysis. Price highs and lows convey much more than a new trader initially thinks they do.

When price makes consecutive ‘Higher Highs’ and ‘Higher Lows’, the price is said to be in an uptrend. On the other hand, when the price showcases consecutive ‘Lower Highs’ and ‘Lower Lows’, the price is said to be in a downtrend. See the chart above.

What is Trendline?

In an up-trending market, many a time, the consecutive valleys follow an imaginary path i.e. trendline. To explain a bit further, if you can connect 3 or more than 3 valleys with a single line in an up-trending market, it is said to be a trendline.

Look at the chart below:

In the chart given above, the price is in Up-Trend, defined by Higher Peaks and Higher Valleys. Observe how the valleys are connected with a single line. The line here connects more than 3 valleys and hence is a valid trendline.

So now you understand what trendline looks like in an uptrend. Let’s go further and see how a trendline looks like in a downtrend.

In a downtrend, instead of connecting consecutive valleys, we try to connect 3 different ‘Peaks’ with a same line to form a valid trendline. Let’s look at the chart below for reference:

Now you know that a trendline sits at the price bottom in an Uptrend and sits at the top in a Downtrend. Trendlines play the role of the most important tool in technical analysis, as you will go further, you will find out the trendlines are the basics of all the chart patterns that a trader makes to predict the Probable move of the market.

How do you trade a trendline?

There are actually 2 ways to trade a trendline. One is ‘Trend-Following’ and another is ‘Trading the Breakout’.

The first method is fairly simple, once you have identified a trendline, i.e. a line with at least 3 price touches, you wait for the price to move back again to trendline for the 4^th time, and when it does, you take the trade. When the price is in an uptrend and makes the 4^th valley which touches the trendline, you GO LONG, and when the price is in a downtrend and it makes the 4^th Peak that touches the trendline, you GO SHORT.

Let’s look at the chart 1 again.

In the chart given above, when the price comes to the trendline for the fourth time, we GO LONG and ride some tasty gains. It happens the same with Downward facing Trendlines to. We GO SHORT when the price reaches the trendline in the downtrend.

The second method is when the price stops following the trendline, i.e. the price retraces back to trendline again, but it doesn’t stop at the trendline and reverse, rather it pierces the trendline and start going to the other side.

In the chart given below, the price was trending downward and comes to the trendline for the sixth time, but rather than stopping and reversing from the trendline, it pierces the trendline and starts going upward. In this case, when the price breaks above a downward-facing trendline, you GO LONG, i.e. you buy the stock. With my risk percentage, I made 9% on this trade.

Let’s look at another trade I took:

Here the price was in an uptrend and we have a valid trendline. The price comes near the trendline for the 4^th touch and instead of stopping and reversing from the trendline, it pierces below the trendline and starts going further down. In this case, when the price breaks below an upward-facing trendline, we GO SHORT, i.e. you sell the stock. This trade was sweet 5%.

For a quick recap:

• In an uptrend, the trendline is made by connecting the valleys and in a downtrend, the trendline is made by connecting the peaks. 
• A valid trendline should have at least two touch points. 
• There are two ways to trade the trendline; Trend Following, Trading the Breakout.

Now that you have understood what a trendline looks like and how to make it, open a chart and start practicing the trendline. Start by joining different peaks and valleys in downtrend and uptrend respectively. The chances are you are going to find many if you look even half-heartedly.

So, this was about the ‘Basics of Trendline’ but there is more to it. Refining the trendline, examining different trendlines, and understanding which trendline has better chances of working in your favor and which doesn’t, takes more than just basics.

Next article: Trendlines (Advanced) is coming soon.