Trend lines are an important tool in technical analysis, for both confirmation and reversal. A trend line is a sloping one drawn between at least two or more important points on a chart. They are commonly used to judge entry and exits on investment timing when trading securities. Trend lines show the direction of the market movement, a simple and widely used approach. A support trend line is formed when a security’s price decreases and then rebounds at a point that aligns with at least two previous support points. See the chart for an example of support and resistance trend lines.
UPTREND LINE
An uptrend line has a positive slope and is formed by connecting two or more low points. The second low must be higher than the first for the line to have a positive slope. Uptrend lines act as support and indicate that net-demand (demand less supply) is increasing even as the price rises. A rising price combined with increasing demand is very bullish, and shows a strong determination on the part of buyers. As long as prices remain above the trend line, the uptrend is considered solid and intact. A break below the uptrend line indicates that net-demand has weakened and a change in trend could be imminent.
One important trend line illustration is the one adjoining the lows on the Sensex monthly chart, which broke down in the month of March 2008, when the Sensex was placed at 15900 levels. It was a sign of major reversal after almost five years. If one would have followed it, he would have been successful in surviving the carnage that followed.
DOWNTREND LINE
A downtrend line has a negative slope and is formed by connecting two or more high points. Downtrend lines act as resistance, and indicate that net supply is increasing, even as the price declines. A declining price combined with increasing supply is very bearish, and shows the strong resolve of sellers.
The more points used to draw the trend line, the more validity attached to the support or resistance level represented by it. Sometimes the lows or highs just don't match up, and it is best not to force the issue. The general rule in technical analysis is that it takes two points to draw a trend line and the third point confirms the validity.
Trend lines are used in many ways by traders. If a stock price is moving between support and resistance trendlines, the strategy is to buy a stock at support and sell at resistance, then short at resistance and cover the short at support. Another is when price action breaks through the trendline of an existing trend; it is evidence that the trend may be going to fail, and a trader may consider trading in the opposite direction.
Steeper the Trend line, lesser the Reliability
As the steepness of a trend line increases, the validity of the support or resistance level decreases. A steep trend line results from a sharp advance (or decline) over a brief period of time. The angle of a trend line created from such sharp moves is unlikely to offer a meaningful support or resistance level.
The writer is director and head of research, Anagram Capital
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