The Right Way to Draw Trend Lines

05/26/2010 12:01 am EST

Focus: STRATEGIES

Trend lines are one of the most used and misused tools in the trader’s toolbox. If you are going to use them, you have to have a consistent methodology that defines when you will draw them, where you will draw them, and what you will do when price touches them. Too many times, I have seen traders draw random lines on charts with the argument that they might not use it, but it’s good to have it there. I tend to disagree– if you don’t have specific rules, then you will draw the trend line you wished were there (which, of course, is the one that supports your current position) rather than the one that actually is there. If you do not have consistent rules, then you are probably just drawing random lines on charts, which cannot help your trading and probably hurts it.

First of all, we should define what we expect out of a trend line. There are legitimate trend lines connecting lows of a move to highs of another move, drawn on a “best fit” effort through the center of price action, or drawn through any number of other chart points. I have not found most of these to be useful in my own trading because I expect something very consistent from a trend line. The main reason I will use a trend line is to delineate the conditions that define the current trend for that market. If the trend line correctly defines those conditions, then penetrations of the trend line are significant.

We will explore some further refinements of using trend lines in a future post, but for now, let’s just focus on the most important element: Consistency. There is one specific price point that a valid trend line should capture without cutting through other prices: The low immediately preceding a new high for the trend. Ideally, the trend line should also extend from the actual beginning of the trend (as it does in the example I’m showing below), but that is not essential. If the trend has accelerated, it will not be possible to draw a single long trend line. Note that the trend line may cut through prices past the high (as the trend line is extended), but it should not pass through any price bars before the low.

Rather than write one epic post, I thought it might be easier to absorb this in several smaller posts. I will wrap this one up here with two parting thoughts and a chart example. First, the trend line defines the limits of the swings that compose the trend, so it is important to be sure there actually are swings before you draw a line. For instance, if you see many consecutive bars where you can draw a line across the lows of those bars (this tends to be common in parabolic moves near the end of trends), a trend line drawn across those lows will probably not be meaningful.

chart
Click to Enlarge

You can draw the line; just don’t expect anything out of it! Secondly, do not cut prices when you draw a trend line. Especially with candlestick charts, it can be tempting to draw lines that cut shadows. Again, you can do that, but if the line already cuts price in the past, why should you pay any attention when prices go through it in the future? In a future post, we will look at a few more refinements in using and drawing trend lines on price charts.

By Adam Grimes, trader at SMB Capital and director of tactical investments at Waverly Advisors

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