What are trendlines and how do you use them?

Many traders use trendline strategies in technical analysis to decipher the market and future trades — however, trendlines do not always guarantee a perfect strategy. Learning how to read and identify a legitimate trendline can be very useful, as many traders can get this wrong.

Chart
Source: Bloomberg

So, what is a trendline?

A trendline is an illustrated line connecting changing key points in a graph, to indicate patterns of directional change. Trendlines visually represent support and resistance in any timeframe by showing direction, pattern and price contraction.

The ability to identify and draw trendlines is one of the most useful tools in technical analysis. While it may seem complicated, a simpler way to understand trendlines is to think of them as lines that connect two or more high/low points that extend into the future.

What are the different types of trendlines?

There are three main types of trendlines: uptrends, downtrends and sideways trends. All three can help determine if there’s a trading opportunity.

Uptrend (higher lows):

An uptrend shows price movement of a financial asset when there’s an upward direction. For the trendline to qualify as an uptrend, there needs to be a visual and continuous upward trend in each peak and trough. Uptrends are the opposite of downtrends and consist of upwards patterns that can be broken if the next low on the chart falls below the previous one.

Uptrends provide opportunities for investors to profit from a trading opportunity until the high-trend peaks are broken. Moving averages can also be used to find uptrends where traders can look for the price that is trading above the moving average.

Rising prices will appear bullish and show a strong determination. When prices remain above the trendline, the uptrend is solid.

Downtrend (lower highs):

A downtrend occurs when there’s a downward pattern - when assets move lower over a certain period. Downtrends can sometimes look like they’re starting to peak but are unmistakeably characterised by lower peaks and lower troughs consistent over time.

A downtrend consists of two types of price waves: impulse and correction waves.

Sideways trends (ranging):

A sideways trend occurs when the result of a price travels between strong levels of support and strong levels of resistance. Sideways trends can sometimes be referred to as horizontal trends, as they appear as horizontal trends that dominate the price action of a specific asset for a prolonged period before changing.

How to use trendlines in forex trading

If drawn correctly, trendlines in forex trading can be as accurate as any other method. However, using them in trading means knowing how to draw them correctly. There are many misconceptions about how to draw trendlines, and some traders try to make the line fit the market, instead of the market fitting the trendline.

Drawing trendlines has some rules to it, it’s important to draw a line connecting two or more peaks/valleys, whether high or low. Peaks and valleys refer to highs and lows created with zig-zagging prices. Below we show an example of how to draw unbroken trendlines.

The best way to use trendlines in forex trading is to look at the extended lines and trade on prices based on the trendline projections.

Incorrect use of trendline

Correct use of trendline

Understanding trendlines in technical analysis

When understanding trendlines in technical analysis it is important to note that two or more high or lows are required to make up a trendline. Furthermore, the more times a trendline has bounced, the more significant it can become.

Identifying a correct trendline can be tricky, and one of the better indications to look out for is if there is a third high/low peak. This is what solidifies a significant trendline, and the more connecting points, the better.

It’s also important to understand support and resistance levels. A support level is determined when the price stabilises as it drops, which means that the price is more likely to bounce from its ‘support’ level.

Resistance levels are the opposite of support levels, as the resistance is where the price tends to find resistance while it rises and so is more likely to bounce than break through the resistance level.

Rising prices will appear bullish and show a strong determination on the part of the buyers. The objective of trendlines in forex trading is to join the high/low trends by drawing trendlines connecting from the bottom up. This will show points of focus for the market price and depict points of support and resistance levels.

When using trendlines in forex trading, it’s important to know how to identify valid trendlines.

There are some basic buying rules to consider when noticing trendlines:

  1. You need a minimum of three swing peaks to draw downward trendlines
  2. You need a minimum of two higher swings to draw an upward trendline
  3. Wait for the price to touch the trendline
  4. Place a buy stop order 2-5 pips above the high of the swing
  5. Place your stop loss 2-5 pips below the swing
  6. Place your target on the previous significant lower peak

When you start to learn how to notice downward and upward trendlines, the process will become easier for you and you’ll start to have a trained eye in finding future trends.

There are also some basic selling rules to consider when noticing trendlines:

  1. You need connect a minimum of two lower highs (or lower swing highs)
  2. Wait for the price to drop and touch the trendline
  3. Place a sell stop order 2-5 pips below the low of the candlestick that touches the trendline
  4. Place your stop loss 2-5 pips above the high of the swing
  5. Place your profit targets on the previous significant peak

The risk-to-reward ratio of the trendline trading strategy is based on price action, which allows you to sell at the peak and buy at the very bottom of the price swing, while maintaining a consistent stop loss.

While there are other strategies that have proven very useful, the trendline strategy in technical analysis remains one of the most popular.

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