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Trendline 101

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We all know how to draw trendlines, but how do we know that they're valid? What are prices likely to do when the trendline is approached next?

In my years writing about technical analysis, I've addressed trendlines previously, of course, but we accumulate new subscribers. In addition, if seasoned traders hang on through the basics addressed in the first part of this article, they'll find some information about combining volume studies with trendline approaches that will help them make decisions about whether the trendline support or resistance will hold.

For newbies, most technical analysts consider a trendline established only if it has three points of contact. Two can be used to establish a tentative trendline. Sometimes, those tentative trendlines turn out not to be the best ones. Sometimes, drawing trendlines also requires judgments to be made.

Note: My articles are often drafted a week or two before they're submitted, so charts are not current, as is true of this article.

Tentative MMM Trendline Drawn Off Two Points:

If that trendline were extended, however, it does not explain the downturn that occurred at the apparent resistance near 80 in January.

Extension of Tentative MMM Trendline:

That illustrates the fallacy of making trendline decisions when you have only two points. That other tip already mentioned is also illustrated: traders must make decisions about where the true trendline lies.

For example, all traders have seen instances when prices pierce an established trendline but then close back below that trendline. Sometimes, before a trendline is even established, prices pierce the resistance zone that's still forming and close lower, effectively piercing and then closing below the trendline that has yet to form. This is also true of rising trendlines: prices sometimes pierce a support zone that is still forming but then close above it.

I can hear the "Huh?" exclamations out there. Maybe a chart explains better.

Best-Fit Trendline

The best-fit trendline drawn here appears to be more valid than one that began as an extension of a short line section that ran along the two November tops. Sometimes traders have to decide whether to draw a best-fit trendline or one that skims the tops or bottoms of each day's candle, depending on whether it's a descending or ascending trendline.

Traders can sometimes validate the decisions made when they've drawn a best-fit trendline. Combining the action of an oscillator such as the RSI with the action of prices near trendline tests sometimes works. I purposely did not handpick the chart or the trendline I would discuss, but focused on the first chart that I pulled, so let's see if we can corroborate this trendline using RSI.

Corroboration of the Trendline's Validity:

An RSI descending trendline can be drawn off the November and January RSI highs, although it's a tentative trendline with only two points. Because of the similar RSI action at each of the price trendline tests, I would consider the price trendline valid, although it didn't have as strong a corroboration from the RSI as I had expected to see. Of course, there's some corroboration in what price action has since done, but when traders were first drawing trendlines on their charts or having a charting program do it for them, they wouldn't have had the benefit of that hindsight.

Or would they? A study of the volume compared to the shape of the days' candles as that trendline is tested might have given them a clue. Although I've always been interested in watching volume--reporting on volume considerations was one of my first inputs to the live Market Monitor portion of our site many years ago--I owe some of current conclusions from my study of Tom Williams' MASTER THE MARKETS. I won't blame him for my mistakes, however, if I should make them when describing what I'm seeing. Any mistakes are mine alone.

Again, remember that I didn't handpick this chart so that it would illustrate what I wanted it to illustrate, but rather am discovering what it shows as I write. Let's see what volume considerations show us as that trendline was tested, and what traders might look for the next time it is.

MMM's Daily Chart with Volume:

As the trendline test continued in January, there were numerous days that produced what Williams calls "no demand" bars. These occur on low-volume up moves that produce narrow spreads (when compared to the bars preceding them). This is not the way big money's participation would be observed if big money were bullish about prices at this level.

Big money can, however, choose light-volume periods to run stops and trap retail traders, however. Consider again that November 30 candle that pierced that best-fit trendline, with prices falling back by the close. November 30 came during the week after Thanksgiving, a time when it might have been easy to run some stops and distribute some stock to retail traders buying the breakout or shorts covering at the breakout.

What would traders see if a stock in a downtrend might be gaining strength, the downtrend nearing its end? See that huge-volume down day at the end of January? Strangely enough, that could be a sign of accumulation beginning, although it's certainly not a sign that retail traders should begin accumulating just yet.

Here's what I mean. I chose another chart at random, scrolling through until I found another chart with a huge-volume down day, with prices bouncing off their lows that day. Why did they bounce?

Annotated Daily Chart of BNI:

So, while traders haven't seen proof that it's time to buy MMM again, bearish traders are at least forewarned that the huge volume seen at the end of January could have been signs that big money was beginning an accumulation of the stock. While a big-volume drop is normally a bad sign, huge volume on a punch to a new recent low, especially if there's a big bounce by day's end, can be a sign that big money has decided to step in and accumulate.

Big money can be wrong, but, more importantly for us retail traders, they can begin accumulating and hold on while momentum propels a stock's price lower, while we retail traders don't have the funds to tie up to do that. So, I'm not counseling that traders should buy MMM right now.

What would traders see on trendline tests in a bullish stock, if that trendline were to hold? They want to see some of the same characteristics pointed out in that last arrow on BNI. They want low-volume small-range tests of the rising trendline with prices bouncing by the end of the day and with prices climbing the next day. They don't want to see volume increasing as prices drop toward that supporting trendline, especially not if that volume is producing big-range candles that close on the lows of the day.

Drawing trendlines requires art, but fortunately we traders have some tools such as corroboration by oscillators to help us gauge when we've gotten them right. We also have volume and price action comparisons to help us gauge whether the trendline is likely to hold or not on the next test.
 

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