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The Power Of Drawing Tools

03/03/08 04:57:50 PM PST
by Larry Swing

Used long before computers, these simple tools can be key in enhancing your understanding of how price action works.

Indicators are not the only tools that can be used to profit from the market. It's convenient to have the mathematical formula and the charts do all the work for you. However, by confining yourself to using only indicators, you are missing out on another side of technical analysis -- the use of drawing tools. Drawing tools could complement indicators, which would improve the accuracy of your entries and exits. This in turn would increase your profitability.

For the most part, the use of drawing tools involves more art than science since most of them are not math-based tools. There are some exceptions, the most common being Gann and Fibonacci lines. Drawing tools are applied on charts manually, which makes them discretionary tools. Here are a few that are useful but effective for charting:

1. Trendlines
2. Horizontal lines
3. Gann lines
4. Fibonacci lines
5. Support/resistance measurements

These are simple tools but can become complex when applied to charts. What is amazing is that prices respond to these drawing tools very well. Actively using these tools will significantly increase your understanding of how price action works.

Trendlines are one of the oldest lines utilized. They have been used since before computers and all the charts had to be drawn up by hand from blank sheets. Since trendlines are drawn based on each price bar, it was a cumbersome task. Today, the convenience of technology has made the process easier, but that comes with a price. The ability to draw and remove trendlines with ease causes more uncertainty and problems in truly understanding how trendlines work with respect to price bars and price action. But overall, technology has helped make the task of drawing trendlines easier.

Trendlines are especially helpful in drawing price patterns such as wedges, channels, pennants and flags, and so forth. Figure 1 is an example of how well prices conform to trendlines.

FIGURE 1: TRENDLINES. See how prices tend to move right along the trendline.

Horizontal lines are used to determine support and resistance levels, whether they happened recently or in the past. They are also helpful in drawing price patterns. For example, ascending and descending triangles and rectangles are drawn with at least one horizontal line. And of course, round numbers are effective and drawn with horizontal lines to the breakout levels. Figure 2 is an example of how a horizontal line is applied.

FIGURE 2: HORIZONTAL LINES. Horizontal lines can be used to identify support and resistance levels.

Gann charting is complex if done by hand. It is time-consuming, tedious, and inaccurate at worst, and messy at best. Thanks to modern software, however, Gann lines can be done in seconds. Gann lines are used to measure the intensity of the trends by the use of the angles of trendlines. The most important trendline angle is 45 degrees. The degree of the ascending or descending angle of price movement indicates the bullishness or bearishness of the trend. In an uptrend, if prices ascend above 45 degrees it means the trend is strong, and if it is below 45 degrees it is not as strong.

Likewise, in a downtrend, when prices descend below 45 degrees it indicates a strong trend, and when it is above 45 degrees it is not as strong. Figure 3 shows an example of Gann lines.

FIGURE 3: GANN LINES. The degree of the ascending or descending angle determines the strength or weakness of a trend.

Fibonacci lines are probably the most valuable and often-used tools among experienced technical analysts. These lines are used to draw retracements, extensions, and projections. When drawn, retracements are used to find the probable areas where prices are likely to stop and reverse back to the direction of the trend. These areas can be 61.8%, 50%, and 38.2% from the nearest high (100%) or from the nearest low (0%). Figure 4 is an example of how Fibonacci lines are placed and how the lines are drawn to see possible support areas.

FIGURE 4: FIBONACCI LINES. These lines are drawn to determine areas of support and resistance.

Any percentages above 100% are either extensions or projections of the likely price targets. On the daily chart of AAPL in Figure 5, Fibonacci lines are drawn from the recent high and recent low, retracing back to 50%, before proceeding to the projected 127.2% and 161.9% levels.

FIGURE 5: FIBONACCI EXTENSIONS. Levels above 100% are considered projections or extensions and are used to identify price targets.

In technical analysis, all price patterns such as triangles, rectangles, pennants and flags, head & shoulders, double bottoms, and double tops have a method to measure the targets or projections of their expected price movements. The placement of support/resistance levels and measurement tools quickly identify the levels and measure the next possible price target. This tool works well when charts form rectangle patterns. In this case, the distance from the support to the resistance trendlines are extended to the upside and to the downside to project the probable price targets, as shown in Figure 6.

FIGURE 6: SUPPORT AND RESISTANCE LEVELS. These lines are useful when prices are in a trading range. Once the support and resistance levels are identified, you can then determine price projections once prices breakout from these levels.

This tool is effective for spotting trading ranges. By placing the resistance line on the highest price of the range and the support line at the lowest price of the range, you can identify a price projection. If a breakout to the upside occurs, an upper price projection is used; if a breakout to the downside occurs, a lower price projection is used. The chart shows the rectangle drawn on a trading range along with the projections on both sides of the range.

Drawing tools are extremely powerful when you become familiar with them. When incorporating with other types of technical (such as indicators) and/or fundamental (such as news confirming price action) analysis, the strategy can be even more powerful and complete in seeing a clearer picture of how and where the stock is and likely to be. These tools help identify where prices are likely to go once a trend is confirmed. This has a lot to do with the anticipation of the crowd's action or behavior.

Larry Swing is the president of the day- and swing trading site, where free daily articles and videos on education, market analysis, and picks from Swing and other well-known traders can be found.

Larry Swing

Larry Swing is the president of the day- and swing trading site, where free daily articles and videos on education, market analysis, and picks from Swing and other well-known traders can be found.


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