“The trend is your friend.”
― Marty Zweig
“The trend is your friend except at the end where it bends.”
― Ed Seykota
Trendlines are the most basic chart “pattern.” They are intended to depict the market’s intent to rise or to fall over time. They are also utilized to identify when that intent has reversed. When drawn properly according to consistent rules, trendlines can do both with some degree of reliability.
When drawn improperly, they still can do both, but only by coincidence.
Even improperly drawn trendlines don’t follow a single set of rules. Following are several rules I use for constructing relevant trendlines:
- Trends begin at the extreme.
- Trends do not begin at the actual extreme.
- The connector is found well after the extreme.
- Exactly what is an “extreme,” anyway?
Let’s start with the last item, and define an “extreme.” When an uptrend is unfolding (uptrend rules are interchangeable with downtrend rules), each new high price might prove to be the trend’s highest. We won’t know in real-time if it is the extreme until a reversal develops into a downtrend. But it is simple to identify the prior high.
The prior high is the last high that was reversed. Obviously, its reversal wasn’t permanent, or there would not be a new high to consider. In between the two highs is a dip, which I call the “interim low.” The first high, which is now the lower high, also gets a label, which I call the “pivotal high.”
Got it? “Pivotal” high was at first the actual high, and then a dip to an “interim low” was retraced to a new actual high, making the prior actual high the pivotal high. That wasn’t difficult.
So, the high prior to the actual high – the “pivotal” high – is the trendline’s “anchor.” The trendline now needs a “connector” to identify the trendline’s plane. Literally, a line is drawn from the anchor through the connector, and extended indefinitely into the future. Just as the pivotal high is the high prior to the actual high, the connector is the high following the actual high. I call this the “key” high. The key high appears after reacting down from the actual high deeply enough to test the interim low.
If there is anything difficult to identifying the key high, it is the wait for a dip under the interim low, and for that dip to bounce. The trendline’s connector, its second identifiable price point, must be below the pivotal high for the trendline’s slope to be downward.
Again, the rules for determining the key high are the same as those applied in determining the pivotal high – that the bounce from under the interim low must be retraced to a new low. The rules may seem like a lot to track, but they are logical and consistent. More important, the rules assure that a trendline won’t be drawn prematurely, which would be misleading and a waste of time.
Now let’s revisit the trendline drawing rules:
- Trends begin at extremes. The trendline’s “anchor” is its first price point. This might seem axiomatic, but even many professionals draw trendlines arbitrarily, beginning during a trend already underway, or from the actual extreme.
- Trends do not begin at the actual extreme. The “pivotal” extreme is the trendline’s anchor. The actual high (or low) has one use, and that is to identify the prior high.
- The connector is found well after the extreme. We can anticipate the trend reversing down all we want. But the new trendline cannot be drawn until there is a deep enough reaction down.
Several other pivotal trendline rules:
The Label Rule: Drawing a trendline from the pivotal high (anchor) through the key high (connector) creates a “pivotal trendline.”
The Degree Rule: The pivotal downtrend line is sloped downward, bisecting the actual high.
The Restraint Rule: If the pivotal downtrend trendline is valid, then no further trending is allowed above it. It may be pierced occasionally, but any such piercing must resolve back down and produce a new trend low. Reversing to print back above one of these piercings usually results in the trend reversing direction.
The Invalidation Rule: If the trendline is drawn by connecting a high pivotal close to a high key close, then even a singular close above the trendline can invalidate it.
The 4-touch Proxy Rule: Breaking the pivotal downtrend trendline on its fourth test should eventually return to the actual high.
In addition to the “4-touch proxy,” I have discovered a number of other qualities and behaviors inherent to the pivotal trendline – the correct way to draw a trendline. Pivotal trendlines are simple to identify visually. They are much more reliable for identifying trends that remain intact, and those trends that have ended. When the chart does not allow a pivotal trendline to be drawn, that is often a clue that the move is not actually trending.