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Trendlines

102

f you only have a hammer, you tend to see every problem as a nail.

--Abraham Maslow

As stated in Trendlines 101 , the job of the trendline is to help you find order in all thoseprice points and determine whether price is going up or down. And it's really that simple, atleast in concept. In practice, however, the trendline is also used to alert the trader topotential changes in the character of the trend and even to reversals of that trend, andthat's a big job for one tool. While it may be true that one tool that performs several taskscan aid efficiency, it is equally true that one tool won't perform all of a variety of tasks aswell as a set of tools, each with a specialized purpose, whether building a shed, repairing acar, or charting the movement of price.

For example, a quandary common among those new to trendlines goes something like Is it alright if I cut through a price bar or bars in order to follow what is obviously (to the eye)the direction of price? or must I cleave to the rule that one must respect the highs and thelows even when it's obvious that price is departing from the line I'm getting ready to draw? Well, if trendlines are the only tool you have in your toolbox, the answer is "It depends". Oryes and no. And no matter which road you take, there remain plenty of potholes, fallen

signposts, sidetracks and detours. Take this example, which is not uncommon.

First you have a rally (1) off what appears to be a bottom (2). Is this a new uptrend? Whoknows? You have to wait for a higher low and a higher high. You get the higher

low (3), but the higher high fails to materialize (4). You then get an even higher low (5),but, again, the higher high fails to materialize (6). These series of higher lows and lowerhighs define trendlessness, so you most likely pull over to the side of the road.

Now price pulls out of this little rest stop and heads downward. But then it pulls upshort (7) and makes what may be a higher low (as compared to the "bottom").Unfortunately, this is of no help unless and until you get a higher high. You could just aseasily be looking at further trendlessness.

Finally, however, you get your higher high (8) and can now plot a trendline (9). Theproblem is that when price pulls back (10), it doesn't come anywhere near your trendline.So now what? When a new higher high is made (11), a new trendline can be drawn (12)which is nearer the action, but that means cutting through a substantial chunk of priceaction real estate. Changing the starting point helps (13), but not much. You now havethree "trendlines". Will the "real" trendline please stand up?

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If one is using trendlines to determine when the trend is changing, much less reversing,knowing just where the line in the sand is becomes more than a matter of idle curiosity.Selling too early can be even more costly than selling too late, if one should not have soldat all. But selling too late can also mean needlessly throwing away what should have beenand could have been profits. Drawing multiple trendlines is not necessarily helpful if doingso lures one into focusing on shorter and shorter "trends" and losing sight of the primarytrend.

The multi-purpose trendline, then, has its drawbacks. But if you have the set of tools,most of the questions above need not even be asked. Let's then take the trendline back tothe store and exchange it for the set (it's on sale), after which we'll tinker further with ourhumble chart.

The primary tool in this set is the linear regression tool, or the regression line . Thissounds pretty heavy duty, but all it does is show you the true direction of price betweentwo points, generally the lowest point (in an uptrend) of what you think is a trend and thehighest point of that trend, or at least the trend up until the time you plot the line. Becauseof the way the line is drawn, it will not only cut through some bars, it will likely cut throughmost of them.

Don't freak at the lines illustrated on this chart. When you draw or plot a regression line,you'll draw only one. Three are drawn here to address the concern that you might haveregarding your choice of "low" and "high" and whether or not they are the "right" low andhigh. The regression line, as it turns out, is extraordinarily forgiving. Even though youmight have trouble hitting the broad side of a barn, you can still come up with a reasonablyaccurate regression line. Here, for example, if you connect the "low" at A with the "high"at B, you get the pink regression line. If you connect the low at A with the "high" at D, youget the blue one. Connecting the low at C with the high at D generates the green one(virtually identical to the blue). But even though several different points are chosen, theregression lines are pretty much the same, and all show an uptrend.

(A cautionary note: the regression line is "offset" and is drawn somewhere other than theconnecting line that you'll think you're drawing directly; this can make you feel slightlybrain-damaged until you get used to it, sort of like writing a letter and staring at amirrored reflection of what you're doing rather than at the paper itself.)

Returning to our humble chart, then, we can dispense with all the trendlines, potentialtrendlines, maybe trendlines, and replace them with a regression line.


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The regression line tells us what the trend is. No wondering. No waffling. But now what?

Clearly the chief job of the regression line is to show trend, not to track all the zigs andzags and meanderings of price as it wends its way from one point to another. For that weneed to select two more tools: the supply line and the demand line . The demand line

tracks the changes in and course of buying interest. The supply line tracks the changes inand course of selling interest. Each of these can be trendlines of a sort, showing the trendsof buying and selling interest respectively, but they can also be perfectly flat, acting assupport and resistance lines, such as in a base or rectangle. The lines can also be quiteshort, depending on how quickly the balance between buying and selling interest shifts andthe one overwhelms and reverses the other, and depending also on whether you want totrade the trees or trade the forest. Thus supply lines and demand lines can be used bothwithin trends and within trendlessness to point to additional trading opportunities thatmight otherwise be missed, as well as to persuade the trader to be patient when the"opportunities" presented aren't especially attractive.

In this case, a demand line can be drawn as soon as there's a higher low (1). When this isbroken, a new line is drawn that conforms to the new lows (2). When this line is broken as

well, new lines are drawn that conform to the next series of lows, successively (3, 4, 5).Eventually, price rests, and buying interest kicks in consistently at the same level (6). Thena new line is drawn that conforms to the next series of lows which happen to begin at alower level (7), then another rest and consistent bounces off the same level (8), all at alower level. Then a line across the next series of lows (9), then the last rest (10).


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As long as the trend is up, one can elect to stay long and draw only demand lines.However, if the presence of trend is not yet clear, much less its direction, drawing supplylines as well as demand lines is a smarter tactic. And even in a an uptrend, supply lines canprovide an early warning of trouble if they begin to fold over and alert the trader tochanges in selling pressure that occur sooner than expected.

Using the same chart, the difficulties price has in making higher highs prompts a supplyline across their tops (11), and since no trend has as yet been established, keeping an openmind is more important than guessing right. When a lower high is made, a new supply lineis drawn (12). After this line is broken and a higher high made, there's no reason to drawany new supply lines until price drops below the last swing high (13). When price breaksthis line and resumes its advance, no supply line is required but (a) the angle of ascent isconsiderably less and (b) there is an odd regularity to how the tops of the bars line up.While sellers are coming in at progressively higher levels, which is good, each successivehigh is not as enthusiastic as it had been during the first leg. Therefore, a supply line isdrawn to highlight all of this (14) just in case it becomes important (note that supply linesdo not have to be angled downward any more than demand lines have to be angledupward; selling interest can kick in at progressively higher levels just as buying interestcan kick in at progressively lower levels). When price then fails to make a higher high (15),the potential importance of that supply line moves up a notch or two. Lower highs thenreceive their share of attention (16).

P lotting both demand and supply lines together can reveal patterns that would likely bemissed otherwise, patterns that would certainly be missed if only standard trendlines orregression lines were used. Since the trend here is mostly up, mostly demand lines are

used. But when the trend is in question, supply lines are brought into play and the patternspop.

There are, for example, a number of "narrowing" patterns here, i.e., higher lows and lowerhighs. These often amount to not much, depending on circumstances, but they often

amount to quite a lot as well, often enough so that the trader would do well to payattention (18). These patterns are addressed later in more detail under "The Hinge".


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What is more important here, though, is the wedge-shaped pattern (20) which is formed just before price gives it up. Buying interest kicks in at higher and higher levels, which isgood, but selling interest turns the tide at lower and lower levels, which is not so good, atleast for longs. All of this jockeying does not end well for buyers.

Because supply and demand lines are much more flexible and much more responsive thantraditional trendlines and regression lines, they are much better able to show thosechanges in the dynamics between buying and selling pressures that signal changes in trendlong before traditional trendlines and regression lines know what's going on. In theseexamples, you have a series of higher highs, the previously mentioned wedge, a series of lower highs, and a cascading selloff, all before the classic trendline is even reached. Thereis a temptation, therefore, to embrace supply and demand lines and dispense with standardtrendlines entirely. However, since supply/demand lines are so much more flexible and hugthe corners so much tighter, the trader who uses them exclusively can easily become sodazzled by twists and turns that he loses sight of the overall trend, i.e., he focuses on thetrees and loses sight of the forest. To guard against this trap without resorting to continueduse of standard trendlines and regression lines, yet another tool can be drafted into serviceto keep you within at least shouting distance of the right track: the moving average .

The simple moving average is in fact a moving trendline, the best of both the traditionaltrendline and the regression line. It may bob and weave and slither in and out of the coursethat price is traveling, sometimes above, sometimes below, sometimes straight through,but it never loses its way, much like a heat-seeking missile. If you begin to feel as thoughyou've lost your sense of direction entirely and are unsure of just where the trend is, themoving average can be a big help, ignoring, like the regression line, the relativelyunimportant zigs and zags, but, also like the regression line, often cutting through thetangle like a broken-field runner and pumping away toward daylight.


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The combination of these tools, then, provides you with information that none of themalone can. The regression line provides you with a clear and unequivocal direction but hasto be periodically adjusted. The moving average, though not arrow-straight, has to beplotted only once, after which it can run on its own, in the background. The supply anddemand lines tell you where the shifts between buying pressure and selling pressure mayprovide profit opportunities, but they can also be so discretionary that the trader becomeslost in nearly simultaneous trends, criss-crossing and curling back on themselves through

multiple time intervals. In short, the regression line and the moving average provide youwith a direction; the supply and demand lines tell you what to do with it and in it.

Trend ChannelsYou may have noticed by now that when selling pressure overwhelms and routs buyingpressure at a steady, regular, measured pace, and buying pressure overwhelms and routsselling pressure in the same way, the supply and demand lines often resolve themselvesinto a channel-like configuration. This is generally referred to as -- you guessed it -- a"channel". And some traders place great store by these channels since making money off of them seems to be easier than falling off a log. However, in most cases, falling off a log is alot cheaper.


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There are at least two problems which one faces with regard to channels. The first has todo with the mathematical fact that going long in an uptrend must -- all else being equal --yield greater profits than going short since the distance from the lows to the highs in theuplegs must be greater than the distance from the highs to the lows in the downlegs (if they were equal, or thereabouts, the channel would be flat, i.e., a base). Same holds truefor going short versus going long in a downtrend. The fact of this generally discouragestraders from trading "counter-trend", i.e., against the trend. But not always. Some insist on

trying it anyway (remember the log), but find that commissions are eating them alive. Andunless they get in at the best possible points in both the uplegs and the downlegs (thisentails not only remarkable agility, but a not inconsiderable degree of luck as well), theyalso lose money on the trades themselves, hence the tendency of more experienced tradersto stay long in uptrends and short in downtrends and let the newcomers trade in theopposite direction. After all , the experienced traders' profits have to come from somewhere.

The second difficulty has to do with the amount of time it takes to recognize the channelitself. Unless one jumps the gun and "sees" a channel where one does not yet exist, he caneasily be whipped around before the channel ever forms, if i t ever does. On the other hand,if he waits until the channel has clearly formed and he can properly assess the potentialreward and its accompanying risk, the channel is often done, obvious to everyone, andready to transform itself into something else.

Nevertheless, these channels can be a useful tool to the trader who is sensitive to changesin them. If one carefully tracks the movements of price up and down within the channel andlistens to what they have to say, he will receive early warnings to what may be importantchanges in pace, direction, and range . Here are shown Stage 1, 2, and 3 Trendlines indotted red. As each higher high is achieved, a new trendline can be drawn, but the angle of

each is less acute, alerting the trader to a lessening of momentum. The supply lines,however, track the progress of this momentum in smaller timeframes and the alert isconsiderably more urgent. If demand lines are also plotted (the original channel dissolvesas soon as the supply lines began to arc), the point at which longs are in real troubleamounts to a big flashing red arrow (non-flashing in this application).


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In the next example, price changes course abruptly without arching. Depending on whenthe trader arrives on the scene, he will draw all the dotted lines or few or almost none. If he arrives early, he'll draw the first dotted demand line, which is broken at "1" , at whichpoint or thereabouts he'll drawn the first dotted supply line, which is broken at "2" . Bynow, he can draw the solid demand line and supply line. When price again makes a higherlow, he draws another dotted demand line, just in case price is getting ready to break tothe upside. But this demand line is also broken, at "3" . With at least two down-angled

swing points, he can now draw another dotted supply line, just in case price is gettingready to break to the downside instead. However, this line is also broken, at "4" .

The situation gets a lot messier at this stage. The resumption of the upmove is much morelabored. The break at "4" isn't nearly as clean as the break at "2" . Not only does it take a

lot longer, but the first attempt doesn't succeed. Instead, it feints up, then resumes itsdecline, dropping to a point just below the "master" demand line. In fact, one could beshaken into exiting here, which, as it turns out, would not be such a bad idea, though tooearly for a short. Of course, if one entered the scene after this point, the opportunity wouldhave passed and be moot. The late-comer could, however, draw a "supplemental" demandline below what would now be two new swing lows parallel to and below the masterdemand line.

P rice now rallies but finds R at the swing high just past "4" just as it did at "2" . But thebreak at "4" doesn't make it anywhere near the "master" supply line as the earlier upmovedoes and the trader can draw a new tentative supply line. Price then drops back below theS/R line, then up to a lower high, then down again, then up again, and so on, enabling thetrader to draw a newer and shorter tentative supply line. This, again, is a much more

abrupt transition than the previous example, but even if the trader were not to notice anyof this until this point, the probabilities would clearly be toward the short side rather thanthe long, and the trader would have time to take advantage of them.

There are even occasions when the planets align and the channel resolves itself soonenough so that you recognize it for what it is and it lasts long enough so that you can dosomething with it (the gray line is a regression line):


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P laying these requires both the willingness and the skill to change direction. What appearsto be a break in one direction is sometimes a fake, and its "failure" to move in the expecteddirection can be a signal that the true direction lies in the reverse (here, the second hingebehaves itself and does just what it's supposed to do).

And, on occasion, that warm milk will kick in and the energy will be expended inhalf-hearted moves in both directions. The trader must take care, though, that he does not

misinterpret a failure of price to immediately plunge or rocket as a prelude to aimless drift.What looks like a fake can often find support or resistance at the apex of the hinge or atswing points within the hinge.


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Overbought/Oversold

Few events excite longs and shorts as much as panic buying and panic selling(respectively, of course; the opposite has led to heart attack, stroke, and blue language).That these are called "climaxes" is somewhat metaphorical of their effect on the body. Therelease of energy that ignites and supports these moves is something to behold, but thephrases "overbought" and "oversold" have become so entangled with indicators thattraders rarely take full advantage of the profits that are being offered to them. Rather thantrust whatever sensitivity they have gained with regard to price movement, traders bailmuch too quickly because the stochastic or the RSI or whatever is above or below this orthat level, after which price often continues on its merry way, leaving them behind in thedust.

But "overbought" and "oversold" have nothing to do with numbers on an indicator's scale.Rather they describe what might be called a "pyramid" scheme gone horribly wrong. To saythat something is overbought means that the pool of potential buyers is getting shallowerand shallower. When the buying energy dissipates and the pool of buyers dries up, sellingpressure wins out, those who just bought find themselves in the red, they can't findanybody to sell to, and price collapses under its own weight. Demand lines can help alertthe trader to a potential overbought condition/buying climax due to the angles of the lines,and an understanding of what "overbought" means can persuade him to at least considersomething like a trailing or follow-stop rather than an outright exit. In this case, indicatorsshowed an "overbought" condition at the circled level.

Here, below, there is no reason to believe that price is not done. The indicators say"overbought". But price is actually only half done.


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But price isn't done. Instead of reversing, it rallies (3) after breaking the trendline andmakes not one but two new highs (4, 5), prompting a mad scramble among those who hadsold to re-enter the long side.

At this point, the triple-cross is triggered, a sudden and dramatic drop below the previoushigh (6), igniting a panic sell-off after a last-ditch attempt to push back the sellers. Priceplummets, and the trader who's on his toes profits while those who were unprepared arewondering what the hell just happened.

The moral of this story? These lines, whether trendlines, regression lines, ordemand/supply lines, handy as they may be, do not control price. Price is gonna do whatprice is gonna do. And it is price action, not the lines you draw above and below andthrough it, that is in the driver's seat.

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