Wednesday, November 18, 2009

11/18/2009 Drawing Trendlines

Good Evening Traders,

First, my apologies for the lack of updates. I have been doing a lot of work recently and haven't been able to devote much time to the blog. I expect this to be the case going forward as the holidays are quickly approaching. I wanted to devote a post to something I use extensively in my trading. Trend lines. An old saying in the market is "The trend is your friend". Read on to see how I use trend lines in my trading.

First, all traders should know what a trend is. Simply said its the general direction of price movements over a given time frame. Identifying trends and riding them is a surefire way to bank some cash in the markets. BUT IF YOU WANT TO MAKE SOME SERIOUS SCRATCH IN THIS GAME YOU NEED TO IDENTIFY WHEN A TREND HAS CHANGED OR IS ABOUT TO CHANGE. There are easily 1,000,000 ways (and about as many technical indicators) to spot the end of a trend but one of the simplest and time tested ways remains drawing a trend line.

You would think that this would be pretty straightforward, but I see so many traders posting charts on with the most bizarre looking trend lines on them. I noticed that people have a tendency to draw a trend line that suits their thesis on the market they are trading. Everyone loves to be right and poor traders always try to rationalize staying in a losing trade any way they can. What's important is having a straightforward system that guarantees you draw a consistent line every time you analyze a trend. Markets are a little like golf in this way, consistency is key!

I learned how to draw a trend line from Victor Sperandeo. No, I don't know Vic personally, although I wish I did! I just bought his book Methods Of A Wall St. Master a couple of years ago. Its a great read and has paid for itself numerous times over. Victor draws his trend lines "FROM THE LOWEST LOW POINT TO THE HIGHEST MINOR LOW POINT PRECEDING THE HIGHEST HIGH SO THE LINE DOES NOT PASS THROUGH PRICES IN BETWEEN THE TWO LOW POINTS." The key is that the line does not pass between prices in between the low points. Lets look at the chart to illustrate this better.

Notice the line goes from the lowest low to the lowest low preceding the high WITHOUT PASSING THROUGH PRICES. Here is how NOT TO DRAW THE TREND LINE

Now this line IS (generally) a "trend line". It does go with the trend, but what makes it wrong is that it passes through prices in two different spots and TOTALLY IGNORES THAT SWING LOW BEFORE THE HIGHEST HIGH. If you were the trader who drew this line you would probably be saying something like "It broke the trend and now is back-testing it. The market is sure ripe for a short!" Now you may be right, but did you draw that line to fit your thesis, or are there certain criteria you looked for first? Do you constantly repeat the same formula every time you draw on a chart? If I gave you any old chart would you draw the same trend line? Are your rules simple and easy enough for anyone to apply? If the answer to any of those questions is "NO" then you are doing something wrong. And likely losing money too.

Here is another good example on CL futures

Once you learn how to properly draw a trend line noticing changes in trends becomes much easier. Same thing goes with staying in a trade. Lets see how that crude chart turned out...

See how I "manufactured" a trade using the red line? It's easy to do that when you REALLY BELIEVE the market is overbought and all your $1900 dollar indicators are screaming short. Meanwhile you wouldn't have gotten too far in that trade. At best you reached your profit target on one or two contracts.

One more thing to remember is TIME FRAME. This method of drawing a trend line, like all market observations, needs to be taken in the context of the bigger picture. I want to look at that same crude chart one more time on a longer time frame. The key here is the white line I added.

Is a change in trend occurring in crude? Depends on how you look at it. In the near term though...It certainly looks like it.


1 comment:

  1. Thanks for the trendline "refresher," Nathan.

    Cheers... HP