Stock Trend Lines.

Technical analysis is built on the assumption that prices trend. Trend Lines are an important tool in technical analysis for both trend identification and confirmation. A trend line is a straight line that connects two or more price points and then extends into the future to act as a line of support or resistance. Many of the principles applicable to support and resistance levels can be applied to trend lines as well. It is important that you understand all of the concepts presented in our Support and Resistance article before you continue.



UPTREND LINES

An uptrend line has a positive slope and is formed by connecting two or more low points. The second low must be higher than the first for the line to have a positive slope. Uptrend linesact as support and indicate that net-demand (demand less supply) is increasing even as the price rises. A rising price combined with increasing demand is very bullish, and shows a strong determination on the part of the buyers. As long as prices remain above the trend line, the uptrend is considered solid and intact. A break below the uptrend line indicates that net-demand has weakened and a change in trend could be imminent.



DOWNTREND LINES

A downtrend line has a negative slope and is formed by connecting two or more high points. The second high must be lower than the first for the line to have a negative slope. Downtrendlines act as resistance, and indicate that net-supply (supply less demand) is increasing even as the price declines. A declining price combined with increasing supply is very bearish, and shows the strong resolve of the sellers. As long as prices remain below the downtrend line, the downtrend is solid and intact. A break above the downtrend line indicates that net-supply is decreasing and that a change of trend could be imminent.

For a detailed explanation of trend changes, which are different than just trend line breaks, please see our article on the Dow Theory.

Scale Setting

High points and low points appear to line up better for trend lines when prices are displayed using a semi-log scale. This is especially true when long-term trend lines are being drawn or when there is a large change in price. Most charting programs allow users to set the scale as arithmetic or semi-log. An arithmetic scale displays incremental values (5,10,15,20,25,30) evenly as they move up the y-axis. A $10 movement in price will look the same from $10 to $20 or from $100 to $110. A semi-log scale displays incremental values in percentage terms as they move up the y-axis. A move from $10 to $20 is a 100% gain, and would appear to be a much larger than a move from $100 to $110, which is only a 10% gain.



In the case of EMC, there was a large price change over a long period of time. While there were not any false breaks below the uptrend line on the arithmetic scale, the rate of ascent appears smoother on the semi-log scale. EMC doubled three times in less than two years. On the semi-log scale, the trend line fits all the way up. On the arithmetic scale, three differenttrend lines were required to keep pace with the advance.



In the case of Amazon.com (AMZN), there were two false breaks above the downtrend line as the stock declined during 2000 and 2001. These false break outs could have led to premature buying as the stock continued to decline after each one. The stock lost 60% of its value three times over a two year period. The semi-log scale reflects the percentage loss evenly, and the downtrend line was never broken.

VALIDATION

It takes two or more points to draw a trend line The more points used to draw the trend line, the more validity attached to the support or resistance level represented by the trend line. It can sometimes be difficult to find more than 2 points from which to construct a trend line Even though trend lines are an important aspect of technical analysis, it is not always possible to draw trend lines on every price chart. Sometimes the lows or highs just don't match up, and it is best not to force the issue. The general rule in technical analysis is that it takes two points to draw a trend line and the third point confirms the validity.



The chart of Microsoft (MSFT) shows an uptrend line that has been touched 4 times. After the third touch in Nov-99, the trend line was considered a valid line of support. Now that the stock has bounced off of this level a fourth time, the soundness of the support level is enhanced even more. As long as the stock remains above the trend line (support), the trend will remain in control of the bulls. A break below would signal that net-supply was increasing and that a change in trend could be imminent.

SPACING OF POINTS

The lows used to form an uptrend line and the highs used to form a downtrend line should not be too far apart, or too close together. The most suitable distance apart will depend on the time frame, the degree of price movement, and personal preferences. If the lows (highs) are too close together, the validity of the reaction low (high) may be in question. If the lows are too far apart, the relationship between the two points could be suspect. An ideal trend line is made up of relatively evenly spaced lows (or highs). The trend line in the above MSFT example represents well-spaced low points.



On the Wal-Mart (WMT) example, the second high point appears to be too close to the first high point for a valid trend line; however, it would be feasible to draw a trend line beginning at point 2 and extending down to the February reaction high.

ANGLES

As the steepness of a trend line increases, the validity of the support or resistance level decreases. A steep trend line results from a sharp advance (or decline) over a brief period of time. The angle of a trend line created from such sharp moves is unlikely to offer a meaningful support or resistance level. Even if the trend line is formed with three seemingly valid points, attempting to play a trend line break or to use the support and resistance level established it will often prove difficult.



The trend line for Yahoo! (YHOO) was touched four times over a 5-month period. The spacing between the points appears OK, but the steepness of the trend line is unsustainable, and the price is more likely than not to drop below the trend line. However, trying to time this drop or make a play after the trend line is broken is a difficult task. The amount of data displayed and the size of the chart can also affect the angle of a trend line. Short and wide charts are less likely to have steep trend lines than long and narrow charts. Keep that in mind when assessing the validity and sustainability of a trend line.

What is Support and Resistance???

Support and Resistance

Support and resistance is one of the most widely used concepts in trading. Strangely enough, everyone seems to have their own idea on how you should measure support and resistance.

Let’s just take a look at the basics first.

Look at the diagram above. As you can see, this zigzag pattern is making its way up (bull market). When the market moves up and then pulls back, the highest point reached before it pulled back is now resistance.

As the market continues up again, the lowest point reached before it started back is now support. In this way resistance and support are continually formed as the market oscillates over time. The reverse of course is true of the downtrend.

Plotting Support and Resistance

One thing to remember is that support and resistance levels are not exact numbers. Often times you will see a support or resistance level that appears broken, but soon after find out that the market was just testing it. With candlestick charts, these "tests" of support and resistance are usually represented by the candlestick shadows.



Notice how the shadows of the candles tested the 2500 resistance level. At those times it seemed like the market was "breaking" resistance. However, in hindsight we can see that the market was merely testing that level.

So how do we truly know if support or resistance is broken?

There is no definite answer to this question. Some argue that a support or resistance level is broken if the market can actually close past that level. However, you will find that this is not always the case. Let's take our same example from above and see what happened when the price actually closed past the 2500 resistance level.



In this case, the price had closed twice above the 2500 resistance level but both times ended up falling back down below it. If you had believed that these were real breakouts and bought this pair, you would've been seriously hurtin! Looking at the chart now, you can visually see and come to the conclusion that the resistance was not actually broken; and that it is still very much in tact and now even stronger.

So to help you filter out these false breakouts, you should think of support and resistance more of as "zones" rather than concrete numbers. One way to help you find these zones is to plot support and resistance on a line chart rather than a candlestick chart. The reason is that line charts only show you the closing price while candlesticks add the extreme highs and lows to the picture. These highs and lows can be misleading because often times they are just the "knee-jerk" reactions of the market. It's like when someone is doing something really strange, but when asked about it, they simply reply, "Sorry, it's just a reflex."

When plotting support and resistance, you don't want the reflexes of the market. You only want to plot its intentional movements.

Looking at the line chart, you want to plot your support and resistance lines around areas where you can see the price forming several peaks or valleys.

Other interesting tidbits about support and resistance:

1. When the market passes through resistance, that resistance now becomes support.


2. The more often price tests a level of resistance or support without breaking it the stronger the area of resistance or support is.