Drawing Trend Lines: One of the significant first steps in analysing a chart is to draw the correct trend line on the chart. The trend line that a trader draws on his chart will, for the most part, indicate whether a trade should be entered from the long side or from the short - that is, whether he would be buying the particular stock or commodity or selling it.
Therefore, it is of utmost significance that we thoroughly understand: a) how trend lines are drawn; b) which of the trend lines are more significant; and c) when do we consider a trend line to have been broken and, as a result, the trend changed. In today's article, we will try to answer the first of these three questions.
When the overall movement of prices is downwards, we draw a downtrend line and when the overall movement of prices is upwards, we draw an uptrend line. As we know, to draw each of these trend lines on a chart we need to have two points to join. Once the two points are determined on the chart all we will need to do is to join these points and extend the line towards the right. The following rules will help you determine the two points on the chart.
For a down trend line we will join two peaks on the chart in such a way that: a) the line starts from the highest point from where the downward move started; and b) it should join a peak before the existing lowest point on the chart, in such a way that the line is not breached by any of the candles before the lowest point on the chart. On the other hand, to draw an uptrend line we will join two valleys on the chart in such a way that a) the line starts from the lowest point from where the upward move started; and b) it should join a valley before the existing highest point on the chart, in such a way that the line is not breached by any of the candles before the highest point in the chart.
This may sound confusing, but with a little practice you will see that it will become absolutely clear and simple. Let us start with the same chart that we used in our last article. Only this time, we will try to put ourselves back in time and understand not only how we draw a trend line by following the above mentioned rules but also how we may sometimes need to keep updating the trend line, as time progresses.
Downtrend Lines: Exhibit A shows a simple downtrend line. The peak at the highest point A is joined to a peak (in this case, C) before the existing lowest point (B), in such a way that the line is not breached by any of the candles before the lowest point (B). A small variation of trend lines used by a number of traders may also be introduced at this point. According to this variation the line is drawn by joining the top of the real bodies of the candles, rather than by joining the top of the wicks of these candles.
Exhibit B shows a line that is drawn by joining the top of the real bodies of the candles and, as a result, the breaching of the line by the wicks (for example at point C) is ignored. Although in this example, there is a very minor difference in the two trend lines, sometimes this difference can be quite significant. It can benefit to keep both the trend lines on the chart so that we know the different levels of prices watched by the various traders in the market.
Exhibit C combines the two trend lines drawn on these two different principles on the same chart. Line 1 is the one drawn by joining the tops of each of the two candles, while Line 2 is the one drawn by joining the top of the real bodies of the two candles. Now, while keeping these two lines on our chart, let us see what happens as time progresses. In Exhibit D, we see the same chart with the same lines, a few days later.
In this chart, we see that at point E, the prices approached the two trend lines but failed to pierce or even touch them and fell back down and made a further lower low at point D. This brings us to another variation that traders can sometimes use with drawing the trend lines. When you see that the prices have fallen farther away from a down trend line, you may draw another trend line starting from the next peak down to a peak before the current lowest point on the chart.
This line should be drawn in such a way that it is not pierced by any candle, before the current lowest point. In exhibit E, we have drawn this line starting from point C (the next peak, after the highest one) to point F. Uptrend Lines: Exhibit F shows an upward move, with its lowest valley at A and its highest current peak at C. The line joins the lowest valley with a valley (B) before the current highest point (C) on the chart.
However, as we have learnt earlier in drawing the downtrend lines, because the prices had risen quite far away from the trend line we can now draw another trend line starting from the valley succeeding the lowest valley and join it with a valley before the highest point C. The line should not be intersected by any candle before point C. Exhibit G shows this second trend line drawn on the chart. We can see in the chart that this trend line was pierced after the highest point C, but not before it.
As long as the price does not make a higher peak than C, line 2 will remain a valid trend line according to our definition of a correct uptrend line. However, as we move ahead in time - as shown in Exhibit H - we observe that the prices touched new highs, making our existing trend line redundant, because it was being pierced by a valley before the highest point (D) while line 1 remained valid. At this point, we'll have to revise our trend line and make a new one that meets the stated rules for current situation. Exhibit I, shows this new trend line.
TRADE WATCH:
USD/CAD: The week closed on USD/CAD at 1.0485. Although, still under the influence of a strong downtrend, the pair seems to be providing an opportunity to long for a small trade. We recommend the following: Buy one lot at 1.0485, another at 1.0441 and a third at 1.0398. Our trade signal would be considered to have failed, if we get a daily close below 1.0398. We must close all lots immediately at such an occurrence.
Conservative traders may enter only the second (at 1.0441) and third lot (at 1.0398). In case of three lots, take profits on two lots at 1.0572 and let the third lot run to test further upside potential. In case of two lots, take profits at one at 1.0572 and let the second run to test further upside potential. Will be back with a follow-up on this trade next week.
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