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TRADER'S NOTEBOOK


Trading Trendlines

02/06/09 12:58:04 PM PST
by Danish Kapur

How can you use trendlines in trading?

Trendlines can be beneficial in trading, but using them can be an art, and how it is applied depends on the trader. Trendlines can be used for both short-term and long-term trading. First, let's go through the basics of trendlines and how to draw them.

CREATING TRENDLINES
I consider a valid trendline as one that touches at least two bottoms or tops and can be extended into the future to get an estimate of coming support and resistance levels. Trendlines do provide a very good estimate of support and resistance levels. Again, how you use these points to trade depends on you. This is the discipline that separates one trader from another.

There are two types of trendlines: the uptrend and the downtrend. An uptrend connects two or more higher bottoms, while a downtrend connects two or more lower tops.

With the uptrend line, when there are two higher bottoms, you can draw a line connecting those two bottoms. You then extend that line into the future; you end up with a trendline that will give you a fairly good estimate of future support levels. Whenever the price of a stock falls to this line, there is a good chance you may have very good risk-reward ratio since at this level, prices are likely to bounce back. So buying closer to trendlines gives you a low-risk buying opportunity and you can place a stop-loss just below the trendline.

But there is always the possibility of things going in the opposite direction. If the stock price retraces close to the trendline and instead of bouncing back up it breaks below the line, you should exit your long positions. You could initiate short positions with a stop above the trendline. This is because once this trendline is broken, it will start acting as a resistance level to further up moves and prices will be less likely to get back above the uptrend line.

Similarly, a downtrend line connects two or more lower tops. Once we have two lower tops, we can join them and extend the line to get an estimate of future resistance. So every time the stock price comes closer to the downtrend line, it provides a low-risk opportunity to go short with a stop just above the downtrend. When the stock price moves above the downtrend line, that indicates that the stock is showing strength. This means you should get ready to take long positions, but you should let the stock establish higher bottoms so that you can draw the newly formed uptrend line.


FIGURE 1: UNITECH, 5/06-7/08. This stock made a bottom in June 2006, followed by higher tops and consequently higher bottoms in July 2006.
CHART BY METASTOCK

SOME EXAMPLES
Here is a real-time example of trading using trendlines. In Figure 1 you see a chart of Unitech from May 2006 to July 2008. This stock trades on the Bombay Stock Exchange and National Stock Exchange of India. As you can see, Unitech made a bottom L1 in June 2006, which was followed by higher tops and consequently higher bottoms in July 2006. Now, there are two points from where you can easily draw a trendline and extend it. That line will act as an area of support whenever the stock price retraces. It will also provide low-risk buying opportunities.

There was another drop in early September 2006, which had the support of this long-term trendline at point L3. This was followed by a significant rise in the stock price, taking it closer to 300-rupee levels in November 2006. Later, when the correction began, it again took support at this long-term trendline at L4 in March 2007 and April 2007, validating the role of trendlines in providing buying opportunities. I should note here that the more the stock price touches the trendline, the greater the importance of that trendline.

There was another good opportunity to go long in Unitech at points L4 and L5, followed by a big rally taking the stock price close to Rs.350 levels. Again, there was a correction that got support exactly at the trendline at point L6 in September 2007. This was another opportunity to add to our long position. I held onto my long position till my stop-loss got hit -- that is, until prices fell below the long-term trendline.

After September 2007, there was a huge rally in the stock price. It moved too far, too fast from the trendline. In situations like these, you can draw another trendline, which serves as the short-term trendline. This will help you take advantage of short-term price movements.

So when prices hit S1 and bounced up after that, you could draw another trendline, joining L6 and S1, and extend it. This will serve as short-term support for the stock price. As you can see, this support level was honored when the stock price fell and took support at point S2.

After hitting support at S2 (another opportunity to add to your long positions), the stock skyrocketed and went on to make an all-time high of Rs.546. This was followed by a sharp decline. When you see the beginning of the correction, one thing you should pay attention to is the support at that short-term trendline.

The stock price struggled at the trendline but ultimately went below that, hitting stops of the short-term long positions. If your objective is to hold for a very long time, you should keep holding your long positions since the long-term trendline is still in place.

As I mentioned earlier, supports and resistances keep changing their roles. When the short-term trendline was broken, it started acting as resistance to up moves, as can be seen in region S resistance (S Res).

Unable to overcome this resistance, the stock drifted down. Now the only hope is a long-term trendline, and if that goes, all long positions should be squared off.

At this point, even the long-term trendline is not able to provide support, resulting in exiting from all long trades and opening up short trades with a stop just above the long-term trendline.

This is what happened as the stock tried to get back above the long-term trendline but was unable to do so as indicated by the L resistance (L Res) region. The stock again started its downward journey, which brought the stock to sub-150 levels. The stock ultimately declined to Rs.25 (not shown).

This way, you have an idea of how trendlines can help spot entry and exit points and how they interchange their roles from support to resistance and vice versa.

SUGGESTED READING
Kapur, Danish [2009]. "Using The RSI," Technical Analysis of STOCKS & COMMODITIES, Volume 27: February.
_____ [2008]. "Trading For Targets," Technical Analysis of STOCKS & COMMODITIES, Volume 26: November.
_____ [2008]."Swing Trading And Market Pace," At the Close, Technical Analysis of STOCKS & COMMODITIES, Volume 26: September.



Danish Kapur

Danish Kapur is a trader, author, and commentator. He may be reached at www.danishkapur.com.

Website: www.danishkapur.com


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