I realized that, in many of my recent posts, I’ve included graphs with trend lines drawn all over them, but I’ve never defined trend lines on this website. Trend lines are one of the fundamental tools used in technical analysis. All of technical analysis is predicated on the idea that prices trend in one direction or another. Trend lines are used in an attempt to figure out whether or not there is net demand or net supply of a stock. That is, while a stock moves in one direction or another, is it the buyers or sellers coming in to control the direction of movement?
There are basically two types of trend lines – uptrend and downtrend. The uptrend line is defined as a line with positive slope which connects series of higher lows followed by higher highs. The downtrend line is defined as a line with negative slope which connects a series of lower highs that are followed by lower lows.
A properly drawn trend line ought to encapsulate three or more decreasing high points (for a down trend) or three or more increasing low points (for an up trend). Furthermore, the trend line ought to pass linearly through most of these increasing or decreasing lows and highs. Otherwise, you are likely looking at an accelerating or decelerating trend and this chart also likely requires either a rescaling or multiple trend lines.
The easiest stock charts to use for trend line analysis can be found at stockcharts.com. The charts here allow for log scale as well as regular price scales and thus allow you maximum control while trying to find trends in price movements. Let’s take a look at a few examples of up and down trend lines.
Here, I’ve drawn two trend lines. First, is a longterm trend which starts at the beginning of the chart and goes on. It becomes clear about halfway through the charting time period that the trend has diverged from this initial trend line as it no longer encapsulates higher lows. Thus, a new trend line is established which shows the acceleration of the up trend.
Here, we see two lines. The one in red is an incorrect trend line (at least given the time period shown). And, the one in green is the true trend line. That being said, the red trend line is the most likely to be drawn by inexperienced chartists who may prefer to link together the two most prominent peaks that they can find. The green trend line better encapsulates the series of lower highs and rightly predicts a trend line break in April of 2002. While the market did sink once again, it did not sink to lower lows and, within a year, the market did bottom.
On a final note, you may have noticed that the graphs here are done in log scale for the pricing. That is, the prices on the y-axis get closer together as they get higher. This is because the spacing of prices is based more on percentage change than on nominal change. That is the spacing from 10 – 20 is the same as from 20 – 40. If you think about it, since the market is driven in the long run by percentage gain. It makes more sense to analyze charts in this manner particularly if you’re looking at a long term graph. If you are using a standard nominally denominated price graph and find it difficult to fit your trend line, it can help to switch to log scale as often times you will find that trends manifest themselves best in this manner.
Now that you know how to properly draw trend lines, continue on to the next post on how to use them.