A trendline is a straight line connecting either a series of ascending bottoms in a rising market or the tops of a descending series of rally peaks. Those joining the lows are called up trendlines, and those connecting the tops are referred to as down trendlines. It is also possible to construct horizontal trendlines joining a series of identical lows or identical highs. Typically, a down trendline is constructed by joining the final peak with the top of the first rally, as in Figure 6.1. When the price breaks above the trendline, a trend change signal is given. The opposite is true for an up trendline (see Figure 6.2).
How to Draw Trendlines
In order for a line to be a true trendline, it must connect two or more peaks or troughs. Otherwise, it will be drawn in space and will have no significance. You will often see people constructing lines that only touch one point, as in Figure 6.3, or even no points at all, as in Figure 6.4. Such lines have no meaning whatsoever, and are really worse than drawing nothing at all. This is because by simply appearing on the charts, such lines give the observer the impression that they actually have some significance.
Consequently, if it only touches one point, it cannot be true trendline.
Ideally, an up trendline is constructed by connecting the final low with the first bottom in the rally, as line AD in Figure 6.5. This is called the primary trendline. In the case of a primary trend, this would be the bear market low and the first intermediate bottom. The example shown here offers a fairly shallow angle of ascent. Unfortunately, the price rallies sharply, which means that the violation develops well after the final peak. In such situations, it is better to redraw the line as the price moves up. In Figure 6.5, this is line BC, which is obviously a better reflection of the underlying trend. This is called a secondary trendline. Down trendlines are constructed using the same principles, but in reverse. Since trends can be sideways, it follows that trendlines can also be drawn horizontally, which is often the case when we construct price patterns such as the neckline of a horizontal head-and-shoulders (H&S) pattern or the upper or lower boundaries rectangles (described in later chapters). In the case of price patterns, the penetration of these lines usually warns of a change in trend, as does the violation of rising or falling trendlines.
Trendline Breaks Can Be Followed by a Reversal or Consolidation
The completion of a price pattern can signify either: (1) a reversal in the previous trend—in this instance, it is known as a reversal pattern—or (2) a resumption of the previous trend, when it is called a consolidation or continuation pattern. Similarly, the penetration of a trendline will result in either a reversal of that trend or its continuation. Figure 6.6 illustrates this point from the aspect of a rising price trend.
In this case, the trendline joining the series of troughs is eventually penetrated on the downside. The fourth peak represented the highest point in the bull trend, so the downward violation of the trendline signals that a bear move is under way. The upward price trend and trendline penetration in Figure 6.7 are identical to those in Figure 6.6, but the action following this warning signal is entirely different. This is because the trendline violation results in the advance continuing, but at a slower rate. A third alternative is that the price consolidates in a sideways trading range and then advances (Figure 6.8).
Finally, it may consolidate and then reverse to the downside. This is shown in Figure 6.9. Thus, whenever a trendline is violated, the odds strongly favor a change in trend. That change can either be an actual reversal or a (sideways) trading range following an uptrend or downtrend.