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Trader's Corner

Use of Trendlines for Price Channels

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First, brief answers to a couple of Subscriber questions, one also relating to trendlines -

What are your preferred settings for MACD, slow Stochastics and RSI for Weekly, Daily and 60 minute time frames? I'm doing some backtesting on TS and would like your inputs as a starting point.

I try to label every chart with my "length" settings (i.e., number of trading periods to use for its calculation) but I don't always show more than Daily and Hourly charts with such indicators. And I don't use MACD (Moving Average Convergence Divergence) all are measures of market momentum, but RSI and (slow) Stochastics are 'normalized' so that these indicators always show a 0 100 scale.

For those who don't know, the MACD indicator is calculated by taking the difference between two exponentially smoothed moving averages of closing prices of 12 and 26-day duration usually these are the only values ever used, although I would just note that Gerald Appel, the trader who formulated the MACD indicator, suggested that a slightly different set of values ought to be used as a sell "signal".

I use the default MACD settings in my charting/technical analysis (TradeStation - TS) application, which are Appel's 12 and 26; TS uses 9 for a MACD moving average and I use that too.

For RSI and Slow stochastics on DAILY charts, I may use 14 for number of days (length), as this is a common default setting. Lately, I've been using 13, part of the Fibonacci number series instead. I also use the next higher Fibonacci number of 21 for slow stochastics and sometimes, for RSI.

For WEEKLY charts, I use 8, which comes before 13 of course, in the 1,3.5, 8, 13, 21, etc Fibonacci number progression. To measure 2 months or 8 weeks is my ideal time frame to look at on a weekly chart.

You mentioned in your last article that you use both trendlines and moving averages sometimes to determine levels for support or resistance. Is one better or more reliable for this purpose?

TRENDLINES are more definitive. Sometimes when there is no nearby trendline, a key moving average like 21, or 50, and 200-day averages, may be the area where trends find support or resistance. This can be shown with the charts of recent market action in a couple of indices

The first chart, of the S&P 100 (OEX) below, shows recent rallies stopping exactly at its minor down trendline. Two highs tentatively establish such a line, but with a third point making a better definition. We now have 5 points establishing the down trendline shown below. Meanwhile, the 21 and 50-day moving averages showed the broad area of resistance, but lacked the greater precision useful for trading.

The lower UP trendline, is where I think good support could develop; assuming there's a move down to this trendline, which I think likely. You can't see where the lower points are in the OEX trendline below. There are only 2 lows "defining" this trendline, so this trendline needs a third point to have more confidence in the intersecting point on the line being SUPPORT.

It's apparent in the COMP chart below that the 21-day average often coincided with support and resistance, as does the 50 and 200-day averages at key times

I You may have noticed in my Index Trader commentaries that I often work with trendline channels, both on hourly and daily charts. Often I use the hourly charts, but my particular charting application also allows me to save a lot of hourly data.

This is not possible on many applications as you take what is given unfortunately. What you can see on the daily chart is what you can also see on the hourly charts, only in better detail

In the S&P 500 (SPX) hourly chart below a series of down, then up trend channels are highlighted. The inability for recent lows to hold the lower end of an hourly uptrend price channel suggests that there could be another down leg here per the down arrow

But then I was also struck by THIS possible uptrend channel on the S&P 100 (OEX) chart, suggesting that support could be found only slightly lower

The technique is simple but you need to also take care of following some rules for it.

A price channel is constructed by drawing a line parallel to
either an up or down trendline that slopes in the same direction.
A trendline is the first requirement, which can be constructed
after 2-3 lows or highs form.

The second, parallel, line can then initially be constructed with only ONE high or low point, which is a concept quite different than the rule for drawing the underlying trendline. Most charting software will place a line parallel to another, as long as you have a starting point or any one point above or below a trendline.

In an uptrend there are minor price swings that go with and
against the direction of the trend. The downswings are used to
define an uptrend line. The top of the first upswing can be used
to define the upper boundary of the price "channel" within which
a trend tends to proceed as seen below, with the construction coming from a chart used in my book (Essential Technical Analysis)

The chart above shows how an uptrend channel is constructed.
The upper channel line in an uptrend tends to define resistance,
or a rising area of selling interest, as prices trend higher.

Note here that after the first 2 downswing lows allowed the
initial drawing of an up trendline, the first rally high AFTER
these two lows, then defined a "line" of resistance not only
going forward, but going back in time as well by extending the
line "backward" from that point. This is an interesting aside
only, as the useful aspect of the upper channel line here is to
see where the next rally highs might come in.

There tends to be 3 results after selling pressure, at the upper
end of the channel, acts in such a "deflecting" manner: prices
continue higher but stay just under or around the upper channel
line, there is a pullback to around the middle of the channel, OR
prices drop back to the low end of the channel back to the
support trendline.

If there is a subsequent high that forms that is above the first
top that has been used to construct the upper channel line, it is
typically redrawn with a parallel line that goes through this
higher high as is seen in the chart below (the chart also comes from my book)

The widest point is used to construct the opposing channel line,
relative to the trendline. This, because we want to see the
widest possible parameters for our channel - in keeping with its
intended use to define potential extremes within the price
boundaries traversed by a trend in its "trajectory".

Please send any technical and Index-related questions for possible use in my next Trader's Corner article to support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

Good Trading Success!!

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