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Trendline

BasicsSometimes it eels like computers

can make things more complicated

than they really need to be. One case

in point is technical analysis. With

aordable computers available to the

masses, it seems like the battle be-

tween sotware makers is to see who

can pack the most eatures into their

programs. However, sometimes the

most simple o analysis techniques

can be just as useul as the most

complex indicators.

Trendlines are one o hallmarks o

technical analysis. This makes sense,

given that technical analysis is built

on the premise that prices trend.Well-known technician John Murphy

wrote this about trendlines in his

book The Visual Investor: The

simple trendline is possibly the most

useul tool in the study o market

trends. And youll be happy to know

that theyre extremely easy to draw.

In this installment o Technically

Speaking, we discuss the basics o

trendlines and how you can use them

in your investing.

A trendline is a straight line that

connects two or more price points.Extending this line into the uture,

it also acts as a line o support or

resistance. There are two types o

trendlinesthe up trend and the

down trend.

Up TrendlineAn up trendline has a positive

slope, meaning it rises as you move

rom let to right on the chart. An

ot-used denition o an up trend

is higher highs and higher lows.

Typically, up trendlines are ormed by

connecting two or more low points

on a chart. The key is that the second

low must be higher then the rst

in order or the line to have a posi-

tive slope. Figure 1 illustrates an up

trend.

Extending the up trendline into the

uture provides a good indication outure support levels. As long as the

trend is up, demand is outstripping

supply even as the price rises. In-

creasing demand in the ace o rising

prices is a bullish sign and as long as

prices remain above the trendline, the

up trend is considered intact.

Eventually, there will be a break

below the up trendline. This occurs

when supply begins to outweigh de-

mand. Breaks below the up trendline

indicate a change in trend could be

coming. Once the up trendline isbroken, chances are it may become a

level o resistance that stifes urther

upward price movement.

Down TrendlineA down trendline has a negative or

downward slope that is ormed by

connecting two or more high points.

The second high must be lower than

the rst in order or the line to have

a negative slope (lower lows and

lower highs). Figure 2 shows a down

trend.

Extending the line orward pro-

vides an estimate o uture resistance

levels. During down trends, supply

is increasing relative to demand even

as prices all. A declining price with

increasing supply is a bearish sig-

nal; the down trend remains intact

as long as prices remain below thedown trendline.

A break occurs in the down

trendline when prices move above

it, indicating that supply begins

to wane relative to demand. Such

breaks above the down trendline may

indicate that a change in trend is im-

minent. However, it is a good idea to

wait until the price establishes higher

bottoms beore drawing a new up

trendline.

ValidationAs we said, it takes two or more

points to draw a trendlineup trend

or down trend. How-

ever, when looking

to draw trendlines,

the temptation is to

merely draw them

through extreme

high and low points.

It is better to draw

a trendline through

points where the

price has momen-

tarily pulled back

and reversed direc-

tion. The more times

prices touch the

trendline, the more

valid the line

becomes as a level o

support or resistance.

Without two points,

This column is devoted to technical analysis, which studies the supply and demand or securities

based on price activity and trading volume. Charts and indicators are used to uncover patterns that

may point to uture price movements.

Figure 1. Up Trendline

Computerized Investing30

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you cannot draw

a trendline. There-

ore, it is not always

possible to create a

trendline.

SpacingThe spacing o the

lows used to orm

an up trendline and

the highs used to

orm a down trend-

line should not be

too ar apart, or too

close together. The

proper distance

between points will

largely depend on the

timerame used withthe chart, as with

all price movement.

Ideally, trendlines are

made up o relatively

evenly spaced lows

or highs.

SteepnessThe steeper the

trendline, the less

valid the support

or resistance level

it represents. Steeptrendlines are caused

by sharp advances or

declines over a short

time period. Prices

that are moving

upward or down-

ward rapidly cannot

be sustained in a trend; eventually

prices will move below or above the

trendline.

Internal TrendlinesThere may be times when you aredrawing a trendline that the highs

and lows will not match up exactly,

perhaps because the angle o the

trendline is too steep or the points

are too close together. In these cases,

you may be able to draw internal

trendlines that ignore one or two

points. However, you should ignore

points sparingly, as the more points

you ignore to t the trendline, the

less meaning the line carries.

The long-term trendline or Potash

Corp. (POT) in Figure 3 extends

upward rom August o 2007 and

passes through the lows in January

2008 and March 2008. These lows

were ormed with selling climaxes

and represent extreme price move-

ments that protrude beneath the

trend line. By drawing the trendline

through these lows, the upward

trendline matches better with the

other lows over this period.

ConclusionTrendlines are a simple way to

illustrate the trend o the marketor an individual security. However,

like any technical analysis tool, they

can generate alse signals i they

are not used properly. Furthermore,

trendlines should not be your sole

decision-making tool. Using other

technical indicators can help you

conrm whether a change in trend is

taking place.

Figure 2. Down Trendline

Figure 3. Internal Trendline

31Third Quarter 2009