With so many different indicators, oscillators, and moving averages making up the science of technical analysis, it is easy to forget about the basics. One basic rule of most trading strategies is to always trade with the trend, and it follows that early recognition of a change in trend would be important. Therefore, it is imperative that we apply techniques to determine what the initial trend is so that we can either trade with it or be in a position to recognize when it has, in fact, changed direction. Drawing a trendline can help us with both of these goals.
BASIC TECHNIQUES
Plotting Trendlines
by Stuart Evens
Drawing trendlines may seem simple, but there is a right way and a wrong way to plotting trendlines.
For our trendline to have credibility or predictive use, the method used to draw it must be consistent, reproducible, and objective. Without a clearly defined method, it is too easy to choose prices through which to draw the trendline based on how we want the line to look because of our preconceived ideas of the market we are charting. Our investment decisions need to be methodical, consistent, and based on facts, not emotions or wishful thinking. Once we have our definitions and our method, we will be able to walk through the procedure for constructing a trendline.
UPTRENDS AND DOWNTRENDS
The trend of a market is the underlying direction of prices during the period being considered. An uptrend consists of prices making successively higher highs and higher lows, while a downtrend consists of successively lower lows and lower highs. A classic definition of the trend is theorem 1 of the Dow theory as put forth by Robert Edwards and John Magee in Technical Analysis of Stock Trends. In it, three movements of two Dow Jones averages -- the industrials and the transportation indices -- are categorized as different trends. The primary trend classifies the market as either a bull market (up) or bear market (down), each with the potential to last many years.
The next movement is described as a secondary reaction or a correction in either a bull or bear market, lasting from weeks to months. The third movement is the daily fluctuation in prices, referred to as the minor trend. It is the combination of these three movements that make up the patterns of price versus time for each specific market.
Now, let's look at a consistent and methodical approach to constructing a trendline.
DRAWING THE TRENDLINE
The first step in constructing a trendline is to choose the time frame: long term, intermediate term, or short term. A long-term time frame will be several months to several years, an intermediate period several weeks to several months, and short term will be less than a day to several weeks. The periodicity of the charts -- that is, intraday, daily, or weekly -- will usually depend on the time frame chosen for trading, but in all cases, the procedure for drawing the trendline will be the same.
For the uptrend, consider a longer-term chart of the Dow Jones Industrial Average (DJIA) during the period of January 1997 to July 1998 (Figure 1). When the market is in a general uptrend, draw a line up from the lowest low (point A) to the highest minor low (point B) preceding the highest high of the period (point E). The lowest low chosen (A) should be one that allows the trendline to be drawn without passing through any price action between these two points.
Excerpted from an article originally published in the December 1998 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 1998, Technical Analysis, Inc.
