Trading with Trend Lines

[Pradeep Narayan]

The quickest & most effective way of trading is by using price as the leading indicator. And the most effective way of determining price movement is through the use of trend lines. It is, therefore, important that we understand price movement and hence draw correct lines depicting the underlying trend.

Price can move only 2 ways – upside or downside. Sometimes, the upside and downside movement can repeat over a period in time & with lesser magnitude. This can cause the price to move in a channel or other consolidation pattern. These consolidation areas, are where the price remains non-trending or direction-less.

Let’s look at the 2 basic price movements in detail:

 

[Pradeep Narayan]

PRICE IN UPWARDS DIRECTION


Price of a financially tradeable item can be said to be in upwards direction when the tradeable item makes ‘Higher Highs’ & maintains the ‘Same Low’ or makes ‘Higher Lows’ over subsequent trading intervals. For example, a stock price is in upward direction when it makes newer highs every trading day. In this scenario, we consider the low price to remain same or move higher.

 

[Pradeep Narayan]

PRICE IN DOWNWARDS DIRECTION

Price of a financially tradeable item can be said to be in downwards direction when the tradeable item makes ‘Lower Lows’ & maintains the ‘Same High’ or makes ‘Lower Highs’ over subsequent trading intervals. For example, a stock price is in downward direction when it makes newer lows every trading day. In this scenario, we consider the High price to remain same or move lower.

 

[Pradeep Narayan]

It is very important to understand the above 2 concepts. The reason is that, our brain has its own biases & pattern recognition schema that often overlook logic. The following diagram would illustrate this:

In the above diagram, there are 3 bars numbered – 1, 2 & 3. The question is, after which bar does the price move upwards? (The stock in the diagram is Wipro – NSE).

The price at bar 1, is in downward direction. Bar 2, has made a lower high but also a higher low. This does not signify anything – except that the stock is no longer in downward direction!

Important Point: A stock no longer downward does not mean the down-trend has changed. In this scenario the stock is still in down trend at Bar 2 (more of this later).

The bar following Bar 2, makes a higher high & higher low. Does this signify a new direction for the stock – could be. But when we look at the next bar, i.e. the Bar 3, we can see that this is invalidated – as Bar 3 makes a lower high, and a higher low.

We can now conclude that bars/prices between bars marked 2 & 3 are consolidation & hence direction-less.

The bars after Bar 3 – at minimum 2 subsequent bars – form a higher high – higher low pattern. This signifies that the price has changed direction to Upward after Bar 3.

If you could see an up-trend from Bar 1 or Bar 2 – your brain just fooled you!

 

[Pradeep Narayan]

UNDERSTANDING TRENDS & DRAWING TREND LINES


In the previous post we discovered how to identify the current price direction of a tradeable item (in our case, stock of Wipro at NSE). A visual interpretation would show prices moving higher or a price in uptrend. But we know how easily we can fool ourselves – as the brain sees what we want it to see!

This would mean we need a well-defined logic to back our interpretation of a trend, just like what we have to define price direction.

 

[Pradeep Narayan]

TREND IN PRICES


Price moves in a direction after making a certain inflection point. In our example, the inflection was at the low point of Bar 3. Here the prices started moving in Upward direction.

The upward movement of price need not progress in a text-book defined pattern of Higher-highs and Higher-lows. There could be instances where the price breaks the previous period low – but still closes above the initial low (or inflection point).

In the figure (our example) the price made the FIRST LOWER LOW at Bar A. This was above the initial low (inflection point) at Bar 3.

 

[Pradeep Narayan]

At Bar A, we have a Lower High & Lower Low pattern. Does this signify a change in direction?


The direction has not yet changed at Bar A!

This is further confirmed at Bar B, where a higher high & a lower low is made. So, Bar A & Bar B represent periods of indecision on price direction. But a line drawn from low of Bar 3 to lows of Bar A and Bar B shows the initial and revised trend line.

 

[Pradeep Narayan]

Let’s now frame the rules for drawing trend lines.


DRAWING TREND LINES


a. Trend line depicting UPTREND connects the LOW of the inflection point to THE FIRST or LATEST LOWER LOW.


b. Trend line depicting DOWNTREND connects the HIGH of the inflection point to THE FIRST or LATEST HIGHER HIGH.


c. Trend lines can only become flatter & never become steeper.


d. An uptrend ceases to be one when the latest price drops below the low of the inflection point.


e. A downtrend ceases when the latest price goes above the high of the inflection point.

 

[Pradeep Narayan]

PUTTING IT ALL TOGETHER

In the figure above, points 1, 2 & 3 represent Inflection points (where direction changes). Horizontal lines at 1 & 2 (3 is very close to 1, hence not shown) show levels the trend change is confirmed. The BLUE line is the Downtrend line and the RED line is the revised Uptrend line. The RED Dotted Line is the initial Uptrend line.

 

[Pradeep Narayan]

TRADING TREND LINES


Let’s see how we can profitably trade using trend lines. We would be using the same example to analyse and execute trades.


SCENARIO 1:

Here Bar X breaks the low of Bar 1 (Inflection Point) signalling Up-trend is not in force. Since the price direction is downwards, there is temptation to short – BUT THERE IS NO CLEAR DOWNTREND LINE. Hence NO TRADE at X.