Trend Lines: How to View Your Charts - Part 2

[RichardCox 10]

Trend Lines: How to View Your Charts - Part 2

 

In part one of this article, we looked at some of the central elements involved when drawing trend lines and identifying how that majority of the market’s momentum can be visualized on your charts. This included factors such as reading your charts from right to left (when finding important support and resistance points), watching price and time in combination and proper trend line construction. Here, we will look at some additional market events (such as support turned resistance / resistance turned support) and the Demark system, which is another method for using trend lines in live trades.

 

Support Becomes Resistance, Resistance Become Support

 

For traders that are more traditionally focused on strategies like range trading, clearly defined support and resistance levels become essential for generating high probability trading ideas. Areas of support are price locations where buyers have stepped in and demand exceeds supply (sending prices higher). Areas of resistance are price locations where sellers have stepped in and supply exceeds demand (sending prices lower). These levels do not need to be static, however, and this is why a downtrend line can also be described as a resistance line, while an uptrend line can also be described as a support line. This is important to remember because it shows that trend lines can be viewed in ways that are similar to static support/resistance points.

 

This also means prices would be expected to behave the same way when these events occur. So, when an area of resistance (or a downtrend resistance line) is broken, that area would now be expected to work as support going forward. Of course, the reverse would be true for broken support trend lines. In the graphic below, we can see a clearly defined downtrend line that acts as price resistance on three separate occasions. On the fourth test, demand overcomes supply and prices rise to new short-term highs. But any declines are limited, as prices are contained by the previous downtrend line below. Prices test this level once again and bounce -- confirming that the downtrend has run its course. Buy positions could have been taken as resistance has now turned into support and propelled prices higher. Sell positions can be established in the reverse scenario (an uptrend line is broken, and then acts as resistance on the following test from below).

 

 

Defining the Levels Most Important to the Market

 

Support-turned-Resistance / Resistance-turned-Support events are important for a variety of reasons. In addition to helping us identify levels where trade entries can be placed, these events also tell us which price zones are most important to the market. For example, if the EUR/USD has consistent trouble rising about the 1.25 mark, a major event would occur if this level was later broken. If 1.25 starts to then act as support (market bears have difficulties pushing prices lower), we would then know the level that concerns most of the market. This is critical for determining sentiment, as we would then know that the market has turned bearish (when prices are below this “line in the sand”) or has become bullish when prices are above.

 

Demark Trend Lines

 

When researching technical analysis techniques, there are several names that pop-up over and over again. One of those names is Tom Demark, and a good portion of his work is dedicated to working specifically with trend lines. Demark’s work forms the basis for many other systems (such as the Mouteki system), so it makes sense to have an understanding how Demark’s approach when choosing your own methods. For Demark, it is critical to have a system for defining support/resistance in order to maintain consistency. Of course, any trend line will require you to connect at least two resistance points (for a downtrend line) or two support lines (for an uptrend line). Generally speaking, a greater number of connected points means a more valid trend line -- and one that will be watch by a larger portion of the market.

 

Here, we will summarize Demark’s trend line system, so that you can draw them yourselves on the charts. First, we must have a common definition of the terms “swing high” and “swing low.” In uptrends, a swing high exists at the upper wick of a price candle that is above the wicks of the price candles that come before and after it. In downtrends, a swing low can be seen at the lower wick of a price candle that is below the wick of the candles that come before and after. The structure of a swing high/low can be seen in the graphic below:

 

 

For Demark, however, there are important distinctions to be made with respect to the number of relevant price candles that surround the swing high/low. For example, the graphic above would mark a Level 1 price point for Demark, because there is one candle on each side of the high/low that matches Demark’s criteria. If the example showed two candles on each side of the high/low, we would have a Level 2 price point, and so on. The greater the number of candles on each side of the high/low, the more significant the price point. Higher level points are the best ones to use when finding chart areas to connect with your trend lines.

 

Rules for Drawing the Trend Lines

 

Given these rules, we can start to look for areas in which to plot the most stable and accurate trend lines.

 

Uptrends:

 

• Focus on the bottom wicks of the candles and find the most recent swing low (reading your chart from right to left).
  
• Moving backward in price history (moving left on your chart), find the next candle in line with higher wick lows to the left and right.
  
• Continue with this approach until there are no more swing lows that meet the criteria (the bigger the number of swing lows, the better).
  
• Draw a line connecting your identified price points, starting from the right of the chart to the left. The left-most point on your chart will be the lowest point in the series, and your trend line will ascend.
  
• Finally, extend the trend line from your right-most swing low (the highest swing low) and extend the line to the end of your chart using the appropriate angle.
  

 

Downtrends:

 

• Focus on the upper wicks of the candles and find the most recent swing high (reading your chart from right to left).
  
• Moving left on your chart, find the next candle in line with lower wick lows to the left and right (the surrounding price periods).
  
• Continue until there are no more swing highs that meet the criteria.
  
• Draw a line connecting your identified price points, starting from the right of the chart to the left. The left-most point on your chart will be the highest point in the series, and your trend line will descend.
  
• Extend the trend line from your right-most swing high (the lowest swing high) and extend the line to the end of your chart using the appropriate angle.
  

 

Conclusion: Trend Lines are Subjective -- But We Can Remove Some of that Subjectivity

 

Trend lines make an important part of most technical trading strategies. But many traders run into problems when there is a lack of discipline and too much inconsistency with respect to obeying your regular trading rules. Innovators like Tom Demark have offered ways of structuring your trades, and this approach has evolved into later strategies like the Mouteki system and others. Most broadly, it should be remembered that trend lines will generally serve the same function as traditional range highs/low in that the will work as support/resistance going forward. But the key difference lies in the fact that trend lines give us the added information of time, where traditional range high/lows only give us price projections.