Using a trend line to enter or exit a trade can be a simple and effective technique to capture profits and/or protect capital. When using trend lines, the first task is to decide where to place the trend line on a stock chart. This may seem simple at first glance, but it can be quite complicated depending on whether a trader adopts a strict theoretical approach, or is more casual about the positioning of a trend line. Assuming a trend line has been decided on, the trader then needs to watch the price and be ready to act if the price crosses the trend line. Naturally, a trader would likely use other trade exits such as stop losses in combination with a trend line. No one strategy or tool should be relied on to protect trade capital.
That said, looking at the example in the image, we can see that the trend line has been drawn under the stock price candles. As it has been drawn under the stock price and slopes upward from left to right, this is an uptrend line. Notice the line has been drawn so as to connect three low points or troughs. It is important to be aware that deciding which low points to use can lead to some quite technical decisions and analysis. There is much literature devoted to the drawing of trend lines using peaks and troughs.
A Google search for Dow or Gann theory will expose an extensive body of knowledge about how to make peak and trough formation decisions. That said, a casual approach might be to simply draw a line of best fit under a stock and decide it is sufficient as an exit signal line. As with all trading though, the key to how to use a trend line is to test the profitability of using any strategy by applying it to historical stock charts. How deep one dives into this process is a personal decision and is not the topic of this blog.
In the case in the image above a trader could say, “the stock is in an uptrend while price stays above the trend line”. Then, while it is below the trend line it could be said to be in a down trend (see image left). The price at which it crosses might be a trade signal. However, this is an oversimplification of what can be a very technical decision making task. At the very least, drawing trend lines requires some practice and a working knowledge of the formation of peaks and troughs.
For the purposes of this blog post, it is sufficient to identify that a trend line is a powerful and efficient means to apply a trade entry or exit signal line. Looking at the images (top) above, it is clear that a trader would prefer to be in the trade as early as possible on the chart shown. Looking at a stock chart like the one above can lead to hindsight bias though. That is, we could say, “wow that exit was very efficient”. However the question is, “when did we enter the trade and when did we draw the trend line?” Is the trend line always useful going forward or do we need to draw a new trend line? The answer is that we can draw many trend lines and where we put them is determined by our time frame and what rules we use to determine where the line is placed. For instance do we need three low points for an uptrend line or more or less? Are we simply drawing a line free hand without using peak and trough theory?
This article cannot delve into the depths of trend line placement and analysis. The take-away is that firstly, there is a wealth of information out there that you can tap into. Secondly, research suggests that properly placed trend lines provide accurate signals about 60-70 percent of the time. Nevertheless, a trend line is not a trading system or strategy in itself, but it is useful tool to consider adding to your trading tool box.
