While conducting technical analysis, an analyst comes across many tools and indicators with which he/she can enhance his/her analytical skills. Trendline is once such tool which is one of the simplest yet most effective one out there with several applications like gauging the current trends or identifying support/resistance areas etc.
Trendlines can be used across the asset classes, and its applications are not limited to a single market or security.
One important aspect of the trendline is its time-independent nature, i.e. a trendline can be drawn on any time frame chart be it daily, weekly, monthly or even on intraday charts like 5 minute, 30 minute etc.
Drawing a trendline is quite simple, but a few minor mistakes may lead one to draw a completely wrong trendline. The primary requirement for drawing a trendline is the existence of a trend without which its practically impossible to draw a trendline, an example of which is a sideways market or a range-bound market.
Now with two kinds of trends (uptrend and downtrend), there are two kinds trendlines to mark each of these.
In an uptrend, where the stock is moving in a series of higher peak and high trough, a trendline is a straight line drawn upwards by connecting two successive lower troughs, preferably from the start of the trend.
In a downtrend, where the stock is moving in a series of lower peak and lower trough, a trendline is a straight line drawn downwards by connecting two successive lower peaks, preferably from the start of the trend.
After drawing a trendline, generally, it is extended into the future with the same angle of ascent or descent for the future projections of support and resistance levels.
A trendline is a tool which is versatile in its usage. Depending upon the experience of the analyst, its uses can be increased for a wider scope. But primarily a trendline serves three basic purposes for which it is used widely.
As the saying goes “Trend is your friend”, identifying a trend is a major part of any form of technical analysis. Without knowing the underlying trend, any form of technical analysis is questionable. There are various methods used for trend identification, of which trendline is one.
By connecting two successive peaks (in a downtrend) and two successive troughs (in an uptrend) the current trend can be identified in a refined and objective manner. Apart from the current trend, extended trendline into the future can also help to gauge the future trend changes.
In an uptrend as long as the stock is trading above its upward trendline, it is deemed to be in an uptrend.
Same goes for the downtrend, as long as the stock trades below its downward trendline, it is said to be in a downtrend.
One major role of trendlines is helping in identifying dynamic levels of support and resistance, which are hard to spot on a naked chart. It is said to be dynamic because these levels keep on changing as time goes by unlike the conventional horizontal zones, which can remain relevant even for years.
In an uptrend, whenever the stock retraces back, it is expected to find the support level around the area where the price and trendline meet in the future. As trendline is already extended into the future, these support levels can be marked beforehand. These support areas are the levels where one can enter to participate in the ongoing trend or to increase the existing position.
Same goes for the downtrend. Whenever the stock gives a rally in a downtrend, that rally is expected to get fizzle out near the level where the price touches its downtrend line. These resistance areas are the sweet spot to sell existing holdings for a better price or initiate a fresh short position.
Apart from gauging the current trend, a trendline also helps to identify the change in the trend. It is equally important if not more in order to carry out a complete analysis.
As long as the stock is trading above the trendline in an uptrend or below the trendline in a downtrend, the trend is considered to be intact. If the price penetrates across these trendlines, then the existence of the ongoing trend becomes questionable and is often an early warning of a trend reversal.
Higher the level of volume coming in at the time of breaking the trendline, stronger would be the confirmation of trend reversal. This could be a critical time to review the existing holdings when the trend reversal is taking place.
As discussed earlier, that trendlines act as a support level in an uptrend and resistance level in a downtrend, therefore the classical concept of support and resistance reversing roles after being breached applies to the trendlines also.
To put it simply, Once the upward trendline gets breached, which essentially means the breaking of a support level then this extended into the future is expected to act as a resistance level for the same security.
The opposite holds true for the downtrend line. Once the stock breaks above the resistance level, then that trendline is deemed to act as a support level in the future.
A trendline is just a tool in the arsenal of an analyst, but how and where to properly apply, the relevance of it etc. all comes with experience and depend on the skills and knowledge of the analyst. Still, there are a few parameters on which one can gauge the strength of the trendline, i.e. how strong the prevailing trend is.
One of the best ways to estimate the strength of a trendline is to see the number of peaks/troughs that are touching the trendline. Higher the number of these extreme points, higher would be the strength of the trendline.
To put it in simple words, a trendline connected with 4 peaks is deemed to be stronger than one with 2 connected peaks.
Longer the prevailing trend, stronger would we the trendline. Therefore, it is also noticed that very short term trendlines do not work much as the existence of the trend has not been established much.
Dead Cat Bounce Dead Cat bounce is a colloquial phrase which is quite popular in the financial markets. The term was coined a long time ago and generally referred to the peculiar behaviour of the price. The phrase denotes a recovery in the asset’s price, often a sharp one after a prolonged downtrend. Sometimes it is also referred to a short but sharp fall, succeeded by an equally sharp recovery. How does a downtrend continue for a long time? Quite often, some securities in the financial markets depict a very long downtrend which may last from a few months to a few years depending on the severity of the fundamental headwinds. These prolonged downtrends are so strong that no support levels can withhold the downtrend and the prices keep on falling. Every support level gets taken out by excessive selling, which pushes the prices even lower. These lower prices force the long holders to liquidate their positions as no visible halt in the downtrend is noticed. This liquidation from existing buyers further fuels the selling, leading to the continuation of the downtrend. As the price keeps on falling, the buyers do not get enough confidence to buy and consequently keep getting overpowered by selling pressure continues the downtrend. So what is the ideology behind “Dead Cat Bounce”? In due course of a downtrend, the security tends to become oversold for the time being. Oversold is a technical term is used for security which seems to have fallen quite a bit in a specified period. In other words, a security that has been continually sold in a specified period tends to reach a level wherein the sellers are no more interested in selling at further lower rates. This is where the buyers’ step in and try to buy these stocks at low prices, leading to an increase in demand over the supply. This fresh buying tends to push the price up hence resulting in a short upside movement or, in technical parlance a “Bounce”. This point is where the downtrend witnesses a temporary upside momentum which is exactly quoted as a “Dead Cat Bounce”. The ideology is “Even a dead cat will bounce if fallen from a great height.” Likewise, a short bounce is quite expected after a prolonged downtrend which does not change the trend as a bounce does not mean the cat has become alive. Image Source ©Kalkine Group Does it signify a reversal from a downtrend? A Dead Cat bounce is an upside momentum, witnessed after a prolonged downward trend, generally near the oversold price region. But it is to be noted that this price bounce is merely a reaction of the downtrend which is often witnessed in the oversold areas. This does not change the entire trend, and more often than not, the trend continues in the primary direction after the bounce fizzles out. Why is it difficult to trade a Dead Cat Bounce? Most of the time it is difficult to trade a move like a Dead Cat Bounce as the bounce is often very quick and short-lived. The overall trend remains negative, which is in contradictory to the short-term bounce. Also, few investors mistake it for the trend change, which often proves to be a mistake. It generally becomes difficult to estimate some key support areas from where the bounce may occur as the downtrend is quite strong and lacks demand to support the price. However, there are some momentum indicators like RSI (Relative Strength Index), Stochastics oscillator etc. which may help to gauge oversold zones from where the bounce may occur. What are the reasons for a Dead Cat Bounce? There could be many reasons for a Dead Cat Bounce to occur on the charts as the sudden demand may come due to numerous reasons. Some of the reasons are Oversold Price As discussed, due to a prolonged downtrend and continued selling the price often comes to a level wherein the sellers are no more interested in selling at these lower prices and at the same time buyers often find a value proposition. This leads to a spike in demand, which ultimately results in a Dead Cat Bounce. Strong support area There are some levels of support on the price chart that are quite prominent. In other words, there are some regions of support which are quite strong and may remain relevant for years. These support levels are generally hard to break at the first attempt, which results in a bounce or a complete reversal. How to profit from a Dead Cat Bounce There are two different strategies when it comes to trading these kinds of sharp and against the trend moves. They are contradictory to each other, but both are based on proven price behaviour. Short Selling the rally As the primary trend of the underlying is still downward, one thought arises to go short on the bounce. This strategy one to participate in the downtrend but with a much better price. If these rallies are met with a resistance level like a falling trendline, horizontal price resistance etc. then these areas are ideal to sell the bounce in a downtrend. Buying into the rally Another opinion arises, why not to participate in the bounce? This strategy can also be fruitful provided the bounce should be stronger and last for a while, which is not always the case. This essentially calls for a very quick decision making while capitalising on the temporary bounce. Bottomline A Dead Cat Bounce is a prolonged downtrend followed by a short-term bounce. These bounces generally don’t last long, and once they fade, the trend continues towards the south. However, sometimes a bounce may also act as a reversal, but for the added confirmation a trader should also look at other signals of a reversal like bullish divergence at the bottom or a double bottom chart pattern.
What is Trend Analysis? Trend analysis is part of technical analysis that tries to predict the future movement of a freely-tradeable asset upon incorporating the historical and the present price behaviour. The rationale behind trend analysis is that what happened in the past is likely to be repeat in the future under the same circumstances. Types of Trend Trends could be broadly categorised into three, i.e., long-term, or primary, intermediate, and short-term. Many famous technicians such as, Charles Dow, Ralph Nelson Elliott have built the foundation stone of trend classification through prominent works like Dow Theory, Elliott Wave Theory, respectively, in the field of technical analysis. Dow Theory Charles Dow – the father of technical analysis was one of the first of the modern technicians to identify and write about the fact that markets trade in trends. The work of Charles Dow which was never formulated until Robert Rhea succeeded William Peter Hamilton in 1932. The non-formulated work of Charles Dow further marked his way to the modern and most popularised theory of technical analysis known as the Dow Theory. Dow Theory is basically built on three principles, which are as below. The behaviour of the trend remains the same regardless of the time frame under consideration, i.e., trends are fractal in nature. The primary, the intermediate, and the minor are the only time horizons, which Charles Dow associated with tides, waves, and ripples, respectively. The trend tends to continue rather than reverse which is perhaps the most important observation as any particular trend is influenced by its preceding larger and next smaller trend. Ideally, analysing a trend is rather simple and plain as compared to other advanced concepts such as Elliott Waves, Point & Figure analysis, of technical analysis. However, it is considerably difficult in practice, and many mechanical trading systems which have remained profitable in the market, have been based on the rationale of jumping on a trend and riding it to its predictable or apparent end. The Direction of the Trend Defining the direction of a trend is one of the most import aspect of trend analysis and primarily, there are only three directional trends in the market, i.e., an upward, downtrend, and sideways (or consolidation). Generally, when prices of a security under consideration show peak and through at higher price levels than the immediate previous peak and trough, the trend is said to be an uptrend. The exact opposite of such a price behaviour is what is considered as a downtrend. However, sideways or consolidation differs in that prices of the security under consideration neither show consistent higher peak and trough nor do they show consistent lower peak and trough. In consolidation, prices tend to oscillate between a price range. How to Identify the Direction of a Trend? The direction of the trend is one of the major building blocks of trend analysis and several methods could be used to determine the ultimate direction of a trend and signs of a directional change in a trend. Some of the most prominent and widely used methods and tools to spot the direction of a trend are as below. Trendlines By far, the oldest and the simplest method for determining a trend is manually drawing a trendline on a price chart. The method primarily suggests connecting the price action over a time horizon under consideration to form a line on a chart by connecting either the highs of the price range or the lows. Therefore, an upward sloping trendline represents an uptrend and a downward sloping line trendline represents a downtrend. Drawing a trendline on a price chart is a method which is often at the discretion of the individual analysing the chart. Some technicians prefer to connect the extremes of trading days, i.e., the high and the low to draw an uptrend line; however, some technicians prefer to connect the closing price of trading days to draw a trendline on a chart. The ideology behind connecting the closing price of trading days rather than the highs or low is that some technicians believe that the closing price is the most important price of the day. And, when a technical analyst uses the closing price to draw a trendline, it is often referred as internal lines. Certain standard rules have been developed concerning trendlines for trend analysis, and some of the most widely known and used rules are as below. The longer the trendline, the more significant the price break above and below it would be. The greater number of times a trendline has been tested, the more significant the price break above and below it would be. The steeper the trendline, the sooner it would be broken. Intraday trendlines penetration should be confirmed before interpreting any directional change. Moving Averages Moving averages are one of the most successful methods next to trendlines used for identifying a trend. A moving average could be defined as a constant period average of prices calculated for successive periods. Ideally a series of market events tend to hamper the price of security whilst increasing its volatility. Moving averages could be a very great tool in such matters as it tend to smooth the price fluctuations over a specified period. Regression Lines Regression is ideally defined as a mathematical formula that can fit two dependent variables in a straight line, which is known as the regression line. A regression line has mainly two determiners, i.e., the beginning point and the slope. Generally, technicians remain interested in the location of the regression line on the chart and to some extent, its slope. The emergence of computational power has made the task comparatively very easy & more effective, and many statistical tools such as Microsoft Excel, various programming languages such as R and Python, and several TA software, have made it very simple to draw a regression line and check for its direction. Ideally, the interpretation of the regression line is that, if it is sloping upwards with fewer outliers, the trend is an uptrend. Likewise, if the regression line is sloping downwards with fewer outliers, the trend is a downtrend.
Elliott waves are price patterns, first discovered by R.N. Elliott in 1930s, who described the pattern’s characteristics on wave principle. The theory was an inspiration drawn from the Dow Theory, which, coupled with some natural observation, emerged as one of the most prominent tools used in technical analysis. Basic Attributes of Elliott Waves Ralph Nelson used wave principles to describe the price movements of the financial market, which later turned into what today is studied as wave principle of Elliott waves. Every wave has a starting point and an ending point in price and time. The basic pattern consists of five individual waves that are linked through time and move together to achieve a direction or a trend. There are two types of waves w.r.t its behaviour, i.e., motive waves and corrective waves. Motive waves propel the market prices up or down, and corrective waves interrupt the main trend and travel in the opposite direction. The Elliott waves are a 5-3 structure, in which, the first five waves are motive with two corrective sub waves and, the last three waves are corrective in nature. Motive Waves and Governing Rules There are two types of motive waves, i.e., impulse waves and diagonal waves. Impulse Waves Impulse waves are the strongest types of motive waves that follow some observational rules and could be identified by a 5-3-5-3-5 structure. Wave 2 never moves beyond the starting point of wave 1, or it could be said that wave 2 never retraces 100 per cent of wave 1; and, Wave 3 is never the shortest; however, it is not mandatory that it should be the longest. Wave 4 never enters the price territory of wave 1, i.e., it neither reaches the starting point nor the endpoint of Wave 1. In an impulse wave, the Wave 1 and Wave 5 are always motive waves (could be impulse or diagonal), Wave 3 is always impulse, and Wave 2 and Wave 4 (sub waves) are always corrective. Some Features of Impulse Waves Extensions In an impulse wave, usually, one of the motive waves, i.e., Wave 1, Wave 3, and Wave 5 is extended. An extended impulse wave is just an elongated wave, and the basic principle underlying wave extension is that, if one motive wave is extended, the other two motive waves should be approximately of the same length. The Elliott theorist usually uses this rule for forecasting the length and time of the future movement or the wave, that would enfold. Truncation Truncation is defined as the process when one motive wave (current) fails to breach the high of the previous motive wave and starts correcting after roughly reaching the high of the previous motive wave. Diagonal Waves Diagonal waves are another type of motive wave, which usually follow the rules governing impulse wave, except one, i.e., Wave 4 never reaches the price territory of Wave 1 – through the starting point to the ending point. Diagonal waves are often contracting in nature, though it could rarely be expanding as well, and there are two types of diagonal, i.e., ending diagonal and leading diagonal. Ending Diagonal In an ending diagonal, sub waves 1,2,3,4 and 5 always take corrective-wave form and is only formed as fifth wave of impulse waves. In an ending diagonal one line connects the termination point of sub waves 1 and 3 of Wave 5, and the other trendline connects sub waves 2 and 4 of Wave 5. The formation of ending diagonal normally indicates trend reversal and a swift or a sharp reversal usually brings the price back to the starting point of the diagonal (which is often the starting point of Wave 5), and sometimes it can correct further deeper. Leading Diagonal On the other hand, a leading diagonal occurs at the beginning of the motive wave and is usually an extension formation of Wave 1. Moreover, the structure of Wave 1 in the leading diagonal is the same as the formation structure of the ending diagonal. The only difference between both the diagonal waves is that leading diagonal forms at the beginning of the motive wave and it often indicates trend momentum (as in after consolidation) while on the other hand, the ending diagonal forms at the end of the motive wave and is often related to a trend reversal. Corrective Waves and Governing Rules As the name suggests, corrective waves are normally retracements of motive waves which are either sharp or sideways. All corrective waves achieve partial or full retracement of the preceding motive waves. While motive waves are relatively easy to spot and act on, identifying, corrective waves could become really daunting, especially for novice traders due to its vast variations. There are basically three types of corrective waves, which could be identified from there structure; Zigzag Zigzag is a sharp, three-wave corrective wave, that follows the 5-3-5 structure. For identification purposes, Elliott theorists label corrective waves in alphabets and motive waves in numeric. In a zigzag, the wave A (which contains 5 sub waves) is always a leading diagonal and Wave C (which also contains 5 sub waves) is always an ending diagonal. Flat A flat is a sideways form of correction that follows a basic 3-3-5 structure. In flat, Wave A and B are always corrective, and Wave C is always a motive wave. Wave B usually retraces more than 90 per cent of Wave A. There are three types of flat that are classified w.r.t the ending and starting point of Wave A, B, and C. Regular Expanded (most common) Running (rare) Triangle Triangle is typically a sideway corrective wave with 5 waves that follow the 3-3-3-3-3 structure. There are three types of triangle w.r.t the relative steepness of its high and lows connecting triangle. (Triangle Diagram) Contracting Barrier Expanding Apart from the three-common structure, corrective waves can also take a series of combination, i.e.; it could show two or more structure simultaneously.
Definition – Stop Loss A stop-loss order is defined as an order to buy or sell once a specific price has been hit. Traditionally developed to limit the loss of an individual in a specific security, once the security moves in the opposite direction of the initial expectation; stop-loss order is modified to enter and exit the market at certain prices. A stop order could be broadly classified into two, i.e., a buy stop order – an order to buy a security at a specified price above the current price and a sell stop order – an order to sell a security at a specified price below the current market price. The stop order can be further refined by adding a limit, aka stop loss-limit order to change the order into a limit order once the stop is triggered. How are Stops Used for Entry and Exit? Stop orders, also called stops could be used to enter or exit an open position in the market, and technicians and traders, who follow technical analysis, use the same to enter or exit a position above and below a resistance level and a support level, respectively. For entry purpose, suppose if a price is approaching a resistance level above which a new trend is expected to develop, a buy stop order could be placed to be triggered if the resistance level is penetrated post a breakout. Likewise, an entry stop order could also be placed to sell short once the specified level had been breached. Contrary to entry stops, exit stops are used either to protect capital from further loss (protective stops) or to protect profits from deteriorating back into a loss (trailing stops) Defensive Stops Both protective and trailing stops are defined as defensive stops as they protect investors against a sudden capital loss or fall in profits. Protective Stops Not every entry in the market goes as per plan and ends up with a profit, and many traders have more losing trades than winning trades, yet many of them are able to take the profit out of the market because of the judicious use of their stops. Traders usually place a proactive stop loss below the price level, where they anticipate that the market would change the behaviour. Once the market reaches that point, protective stops usually get triggered, taking the trader out of a bad trade, and when the market does not reach that price level, the protective stops allow the trader to run the trade until reversal sign emerges. Furthermore, protective stops also decide what capital risk the trader or investor is accepting in a trade. By selecting a capital risk, establishing a stop level, and placing an order to that effect, the trader knows exactly what capital risk is being taken. Protective stops are usually placed around the crucial resistance or the support level, only. Trailing Stops A trailing stop could be used to avoid the potential loss of profits when a trade is already in profit for a trader. Many technicians or traders also call trailing stops “progressive stops”. These trailing or progressive stops are necessary because, in a major trend, the prior support or resistance may give a substantial price distance from the current price; thus, putting the capital gain on a risk. Trailing stops are usually favourite among trend traders, who systematically change their capital risk with the directional trend of the underlying security. How Directional Traders Generate Trailing Stops? Trailing stops using a trendline One of the easiest methods of identifying or generating a trailing stop is to follow the trend line with a confirmation filter. Confirmation filters such as close filter, percentage filter, volatility filter, along with the trendline, is a very good method of identifying a strong level for trailing stops while avoiding price whiplashes. However, this method requires daily monitoring and readjustment of the stop level, and another shortcoming of the method is that it does not take current volatility into consideration while deciding the trailing stop. Chandelier exit Chandelier exit method considers only the price and the intrinsic volatility to decide on the trailing stop level via measuring some fraction of the security’s Average True Range (or ATR) from its latest reversal point. Suppose on a given day a stock reversed from $100, and the present 14-day ATR is 5. Based upon the market strength traders usually decide a multiple of 14-day ATR below which they would like to place a trailing stop. For example, a trader may choose to take a 3x of ATR to decide the trailing stop while another may choose to take 6x of ATR for the same purpose. Parabolic SAR Many trend followers use parabolic SAR to decide the trailing stop. Originally developed by Welles Wilder in 1978, SAR stands for “stop and reverse”. Changing Stops and A Lesson To Abide The most important underlying principle concerning defensive stops is that they should never be moved away from the trend of security as they imply that the original analysis was wrong. A trader or investor, who changes or cancels the stop loss, especially when the underlying security is trading at a loss, generally lacks discipline and are more prone to emotional whiplash or emotional decision pressure, which is one of the leading cause of capital loss in the financial market. Do you need stop-loss if you are winning and losing big? Consider a situation, where there are two traders; and the annual returns generated by them are as below: At first glance, it might look like that Trader A is clearly outperforming Trader B with a mean average return of 55 per cent over 4 years as compared to the Trader B’s mean of just 36.0 per cent in the same tenure. However, one needs to analyse the above data with elementary maths and one important thing about investment returns, i.e., they are multiplicative in nature rather than addictive. So, if we assume that both the traders had $100 as an initial investment, let us take a look at their net profitability at the end of Year 4. Despite a large gain profile and a higher mean average return of 55.0 per cent, Trader A ends the session with a net loss of 53.2 per cent. And, despite a low gain profile and a low mean average return of 36.0 per cent, Trader B ends the session with a net gain of 241.43 per cent. Conclusion If you have made a 10 per cent return instead of 25.93 per cent, it will take you ~2.5 years to grow your money by 25.93 per cent instead of one year; however, if you lose 25.93 per cent in the first year, it will take some time to reach breakeven. Thus, it becomes paramount to always limit your loss and be aware of your capital risk.