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Investing Tools: The Simplicity of the Trendline

Posted June 2, 2011

Topics: Finance & Investing

The trendline is a simple tool that makes it easy to spot trends and, even better, when those short-term trends are about to end. You can draw a trendline on any chart and spot when the rising support or declining resistance is slowing, evening out, or reversing.

The trendline is simply a straight line tracking the direction of the short-term trend. An uptrend requires the trendline to be drawn beneath the rising support. A downtrend is a straight line drawn above the falling resistance. This assumes, of course, that support and resistance are moving in the indicated direction of the trend, as they usually do.

In some cases, an uptrend combines rising resistance along with flat support. However, this expanding triangular pattern is likely to reverse quickly. A true uptrend should contain increases, both in resistance and support. The same is true for downtrends. They can consist of flat resistance and falling support, a broadening triangle moving in the opposite direction. Here again, a true downtrend should contain declines at both ends of the trading range.

To spot when reversal of an uptrend is likely, draw the line under support so that it rises with the trading range. Once the support level begins to fall downward and run into the trendline, it could be a signal that the uptrend is about to end. Of course, this indicator should be confirmed by price oscillators, MACD, chart patterns, narrowing daily trading range, volume spikes or candlestick movement.

The downtrend is likely to be ending when the falling trendline is interrupted. Draw a straight line above the trading range of each session and bring it downward as the range declines. Once you see that prices are beginning to rise above the falling resistance level and running into the trendline, it signals a likely reversal. Again, confirm the possible reversal with other technical indicators.

The trendline should never be used alone as a sign of reversal. However, it does give you an early warning that the current trend may be about to turn around and move in the opposite direction. When that occurs, pay attention to the new resistance and support levels. A breakout, even in a rising support or falling resistance level, could flip around. So previous resistance could mark the spot of the new support level in a turnaround and new uptrend. And previous support could become the new resistance level in a newly established downtrend.

Trendlines are easy to spot, easy to draw, and provide a great early warning system for possible price and trend reversals. Unlike many more subtle technical signals, these can provide a fast and reliable means to at least generate more focus and attention during the current trend. The sooner you spot the possible reversal, the greater your chances of timing your buy or sell decision with greater accuracy.

Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches three options courses: “Swing Trading with Options,” “The Amazing World of Options,” and “Synthetic Options Strategies.” He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to the CBOE blog and to the Seeking Alpha blog.