As a basic, we can recognize two types of trend lines: Uptrend and Downtrend.
An uptrend line has a positive slope and is formed by connecting two or more low points. The second low must be higher than the first for the line to have a positive slope. Note that at least three points must be connected before the line is considered to be a valid trendline.
Uptrend lines act as support and indicate that net-demand (demand less supply) is increasing even as the price rises.
A rising price combined with increasing demand is very bullish and shows a strong determination on the part of the buyers. As long as prices remain above the trend line, the uptrend is considered solid and intact. A break below the uptrend line indicates that net-demand has weakened and a change in trend could be imminent.
A downtrend line has a negative slope and is formed by connecting two or more high points. The second high must be lower than the first for the line to have a negative slope. Note that at least three points must be connected before the line is considered to be a valid trendline.
Downtrend lines act as resistance and indicate that net-supply (supply less demand) is increasing even as the price declines.
A declining price combined with increasing supply is very bearish and shows the strong resolve of the sellers. As long as prices remain below the downtrend line, the downtrend is solid and intact. A break above the downtrend line indicates that net-supply is decreasing and that a change of trend could be close.
High points and low points appear to line up better for trend lines when prices are displayed using a semi-log scale. This is especially true when long-term trend lines are being drawn or when there is a large change in price. Most charting programs allow users to set the scale as arithmetic or semi-log.
An arithmetic scale displays gradual values (5,10,15,20,25,30) evenly as they move up the y-axis. A $10 movement in price will look the same from $10 to $20 or from $100 to $110.
A semi-log scale displays incremental values in percentage terms as they move up the y-axis.
A move from $10 to $20 is a 100% gain and would appear to be much larger than a move from $100 to $110, which is only a 10% gain.
The general rule in technical analysis is that it takes two points to draw a trend line and the third point confirms the validity.
It takes two or more points to draw a trend line. The more points used to draw the trend line, the more validity attached to the support or resistance level represented by the trend line. It can sometimes be difficult to find more than 2 points from which to construct a trend line. Even though trend lines are an important aspect of technical analysis, it is not always possible to draw trend lines on every price chart.
Let’s see this chart.
In this example, the chart of Microsoft (MSFT) shows an uptrend line that has been touched 4 times.
After the third touch, the trend line was considered a valid line of support. Now that the stock has bounced off of this level a fourth time, the health of the support level is enhanced even more.
As long as the stock remains above the trend line (support), the trend will remain in control of the bulls. A break below would signal that net-supply was increasing and that a change in trend could be close.
The lows used to form an uptrend line and the highs used to form a downtrend line should not be too far apart, or too close together. The most suitable distance apart will depend on the timeframe, the degree of price movement, and personal priorities. If the lows (highs) are too close together, the validity of the reaction low (high) may be in question. If the lows are too far apart, the relationship between the two points could be suspect. An ideal trend line is made up of relatively evenly spaced lows (or highs). The trend line in the above MSFT example represents well-spaced low points.
But take a look at the other example. Let’s see Wal-Mart (WMT) above. The second high point appears to be too close to the first high point for a valid trend line. However, it would be practical to draw a trend line beginning at point 2 and extending down to the reaction high.
Trend lines can offer great insight.
They can also produce false signals if you do not use them properly. The trend lines have become a very popular aspect of technical analysis.
But, they are merely one tool for establishing, analyzing, and confirming a trend. Trend lines should not be the final arbiter but should serve only as a warning that a change in trend may be close. By using trend line breaks for warnings, investors and traders can pay closer attention to other confirming signals for a potential change in trend
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The minimum of points that must be connected in order to have valid trendline is…
What does the arithmetic scale display?
Trend lines can produce false signals