Trendlines are an indispensable part of conducting technical analysis. Whether you are trading a volatile stock or the most stable Forex pair, you can always rely on using trendlines to find the directional movement of the asset you are trading.
You see, there are plenty of resources on the Internet that extensively demonstrate the procedure to draw a proper trendline. However, if you have read a few of these by now, then you can relate to the utter confusion some of these methods can create.
While the process of drawing trendlines is rather straightforward, after several tries you can easily master the art of drawing trendlines. But then again, using trendlines as part of a broader trading system requires a lot of perseverance and hard work.
The secret of drawing an accurate trendline is understanding how many support and resistance levels it connects on a price chart.
Figure 1: Identifying Higher Highs, Higher Lows, Lower Lows, and Lower Highs on a Price Chart
As trendlines work as a form of visual aid to professional traders, they often first identify the direction of the market by looking at the higher highs and higher lows during an uptrend or the lower lows and lower highs during a downtrend.
The first step to successfully draw a perfect trendline would be mastering the art of identifying these areas of support & resistance without using any additional technical indicators.
Once you have learned to identify these levels, drawing a trendline would turn out to be a walk in the park, where not water, but pips flow from the fountains!
Figure 2: Drawing Uptrend and Downtrend Lines by Connecting the Support & Resistance Levels
Most, if not all, technical analysis software packages include a tool to draw trendlines. If you are using popular trading platforms like the MetaTrader 4, you just need to select the Draw trendline tool in order to start the process.
In order to draw a downward-sloping the trendline, which is called a downtrend line, you need to select the Draw trendline tool from the overhead toolbar, click and hold on the highest peak on the chart, and try to connect as many lower high areas as possible, then just release the mouse button.
In the same way, to draw an upward sloping trendline, which is known as an uptrend line, you just need to select the same Draw trendline tool. However, this time, you need to click and hold on the lowest price point on the chart, and try to connect as many higher low areas as possible, then release the mouse button.
Please note that you do not need to connect all the support and resistance zones, which you have previously identified. However, you should connect at least three of such areas to draw a valid trendline; regardless you are trying to draw an uptrend or a downtrend line.
While drawing the first trendline, if you have left a major area of support and resistance, you can try to draw another trendline using other minor peaks & valleys.
For example, in figure 2, we have left out one of the lower high levels, because it was not aligned with the other lower high levels. If you want to draw a second downtrend line using the first lower high, you can also go ahead. Nonetheless, it is recommended that you stick to drawing major trendlines as it would improve your odds of winning.
Since the price of an asset usually bounces up and down during a range bound market, trying to trade using trendlines can turn out to be a nightmare.
Therefore, if you ask professional traders about what is the best way to use a trendline, they will tell you that trendlines work best when you use it as part of a broader trading system to trade only during a trending market condition.
During a trending market condition, the likelihood of a corrective retracement of price resuming the prevail trend remains much higher.
Hence, you should draw a trendline and simply wait for the price to come back to test the next projected area of support and resistance around the trendline. When the price is about to touch the trendline, you can either wait for price action to confirm that the asset price is about to resume trend, by forming a pin bar or outside bar, or look for signs of divergence using technical indicators, such as MACD and/or the Relative Strength Indicator.
In a perfect world, you will likely find technical divergence as well as a price action confirmation bar indicating that the prevailing trend is resuming after touching the trendline. However, when there is a strong trend, merely setting a pending limit order near the trendline with a tight stop-loss can offer you some of the highest risks to reward ratios trades.
The beauty of incorporating trendlines in your trading strategy is that it gives you an idea of where the price would likely to find support or resistance next.
As you can imagine by now, there is more than one way to trade the market using trendlines. You can use it along with technical indicators to find divergence, or use the trendline projections to predict future support and resistance levels, and apply price action setups.
Also, armed with the predictive capacity of the trendline to find future areas of importance, you can zoom into the market using lower timeframes and get into the trade much earlier using a smaller stop-loss. At the end of the day, any technical analysis tool, including trendlines, would be as useful and productive as your overall money management strategy.
Therefore, trendlines can not only function as a standalone trading tool, but it can significantly improve the overall rate of return of your existing trading strategies.