Option Investor
Trader's Corner

Constructing Trendlines and Trend Channels

HAVING TROUBLE PRINTING?
Printer friendly version

I've written recently, in both this column on Wednesdays and in my recent weekend Index Trader's column, about the tip off supplied by constructing trend 'channel' lines as they highlighted technical 'resistance'. Resistance is usually thought of as where a stock or an index hits approaches or touches a PRIOR high. Support/potential buying interest is implied by the opposite; i.e., an area where the price of a stock or stock index approaches a prior low.

However, there is also technical support implied by a pullback to an up trendline or resistance (potential selling interest) implied by an rebound to a down trendline. Up trends are 'defined' not by a series of higher highs so much as by pullbacks in a series of higher (reaction) LOWS; an up trendline of course slopes up. The more steep the slope, the stronger the uptrend.

Downtrends are defined by a series of lower relative lows made on rallies. Constructing a straight line connecting 2-3 or more reaction lows, makes a trendline when that line is extended out, into the future as it were. A down trendline connects 2-3 or more rally highs and the trendline slopes down.

There is another aspect of trends in technical analysis, which is that of trend CHANNELS. In recent weeks and months the trend has been higher and the DOMINANT trend and trendline has been up. There is no way to measure RESISTANCE using an up trendline; its usefulness, whether on a short-term (e.g., hourly), intermediate-term (e.g., a daily chart) or long-term (e.g., a weekly chart), is to suggest areas of support on pullbacks.

However, construction of a line drawn parallel to the rising up trendline will often highlight a rising level of technical resistance. This is true also for a line that is constructed parallel to a falling down trendline, as that lower line will often highlight support. There are always downside reversals and pullbacks along the way in a bull market trend and upside reversals and rallies in a bear market trend.

Since we're interested in TRADING, there are times when the next best trade is one that is contrary to the direction of the dominant trend. Hence the usefulness of any drawing or charting tool such as the construction of trend channels, that might define resistance where it can't otherwise be guessed at; e.g., in a move to new highs and with no prior peak that suggests potential resistance.

I haven't said specifically yet how an upper or lower channel line is constructed. Better is to show it step by step. Keep in mind also that the same constructions may be applied to any stock and it just happens that my chart examples use stock indexes. The same methods can be also used in intraday charts (e.g., hourly), daily or weekly charts. I'll start with weekly chart examples of the Dow 30 (INDU), then move to hourly examples.

CONSTRUCTING A TRENDLINE:

At least two reaction lows, with the second being higher than the first, is needed to began construction of an up trendline, as can be seen above in chart #1, where the tentative up trendline in the INDU weekly chart is from late-2002/early-2003. Extending this line up to the right (into a future time frame) may prove to highlight a future area of support and give us a THIRD point later on that falls at the up trendline. 3 or more points from which to construct a trendline makes for a 'superior' or more 'reliable' support/up trendline.

The other point to make here is that there are two TYPES of trendlines: 1.) The conventional way is to draw a straight line that touches only the LOWEST lows in order to construct an up trendline and only the HIGHEST highs to construct a down trendline. 2.) An 'INTERNAL' or 'best-fit' trendline is a line that touches the MOST number of lows in an up trendline, or the MOST number of highs in an internal down trendline. I tend to call both types, simply trendlines. However, when you see a trendline cutting THROUGH one of more lows or highs, it is a best-fit or internal trendline.

The third reaction low in the weekly INDU chart came years later than the first two lows that initially established a tentative up trendline for the weekly INDU chart as seen below. After low #3 occurred, the most number of weekly lows establishing this up trendline was to construct an internal up trendline cutting through one low occurring just after the number 2 weekly low noted on the up trendline below.

ONCE THERE'S AN UP TRENDLINE, CONSTRUCT AN UPTREND CHANNEL:

My next chart (3) adds an upper trend channel line by constructing a parallel line to the lower up trendline; one that touches the highest high(s) preceding the last low used in constructing the trendline. The upper parallel channel line seen below, extended to the right, is the assumed future high or pause point for the rising trend. After recent weekly highs, the last of which is highlighted with a red down arrow, came up to the area of the upper trend channel boundary, counter-trend declines have followed. Even if a trader failed to go into puts, much could be gained by exiting calls with most of the gains intact.

A SECOND ADD TO THE CHART; THE RSI INDICATOR

What I consider an important addition to any trend channel that I construct and use is the Relative Strength Indicator or RSI. In the case of a weekly chart I set 'length' to 8 or 13. With such a powerhouse trend as the one we've been in, I use the longer fibonacci 'length' setting of 13; i.e., using the last 13 closes to calculate the RSI level. What I am looking for is the confirmation of a possible top NOT ONLY by a move to potential resistance at the top end of the uptrend channel, but ALSO, either an overbought reading (e.g., at or above 70) OR a high not 'CONFIRMED' by a similar new high in the RSI indicator.

An example of price/RSI 'non-confirmation' is highlighted in my next INDU weekly chart (step 4). Such price/RSI divergences are usually suggesting that the stock or index in question is at or near at least an interim top. The question of any high being a 'final' top is not something that can be determined by these techniques or methods. We're just looking for high probabilities of enough of a downside trend reversal to make it advisable to exit call and/or also make it worthwhile to get into puts.

A similar uptrend channel pattern has been traced out by the Nasdaq Composite (COMP) as seen in my next weekly chart. The differences are that the high noted at point 1 was not in the immediate area of the top end of the price channel, rather was only approaching it. The 13-week RSI WAS registering the kind of high reading often associated with a top as noted by the first down red arrow on the RSI portion of the chart.

However, when the next rally carried to potential resistance implied by the top end of the broad uptrend channel (2nd red down arrow) and the RSI again was at a typical peak reading, this pattern had two reversal elements; e.g., that of resistance implied by the chart pattern and as implied by an "overbought" RSI.

As could be seen from today's rebound from intraday lows and is fairly typical of long-standing strong bull market moves, this market is not going to just collapse. What is more common is to see prices stall for a while, then start moving lower over time in a definite decline. Bull market trends, as well as bull markets die hard, as buying on pullbacks is the habitual reaction. Stay tuned on that!

To show how trend channels can be useful on the shorter-term hourly charts, and using the RSI also (length setting here equal to '21'), the following hourly Dow charts and their comments are presented:

The next chart of the hourly Dow is just a more recent view of the same trend channel construction as above, allowing a more detailed examination of the trend channel. Not everyone has the capability to see so much data for an hourly chart. Most charting applications that reside on your computer, will allow quite a lot of hourly 'bars' or periods to be seen, whether you pull in the data from your chart service or if that data is stored (locally) in your PC's hard drive. The longer the better is my suggestion in terms of how much data to keep or look at in terms of hourly charts.

Note how a rebound to the previously broken up trendline seen below, formed an apparent 'line' of resistance subsequently; if INDU had managed to pierce that lower trend channel line and get back into its prior uptrend channel, it would have suggested exiting DJX puts. The recent rally occurred from the 13400 area which I had pegged as a next key INDU support. Stay tuned as to whether this recent low is just a way station to further declines late on or not! So far, I think 'way station' only.

The upper end of price channels are not always of course so useful in highlighting potential reversal points or key areas of technical resistance and areas where price reversals may occur. Sometimes reversals come out of the blue so to speak, at least in terms of technical/chart patterns. The DIVERGING price/RSI pattern seen below in my last chart, that of the hourly Nasdaq Composite (COMP), did suggest formation of a possible top. The projected channel drawn below was not really a key aid in seeing this last COMP top develop by a reversal around the upper end.

The most recent rebound did however also come back to, and reverse AT, the hourly COMP uptrend line at the red down arrow, suggesting that this index was still running into selling on rallies and a lack of enough buying interest to propel prices back into its uptrend channel; back into its prior trajectory so to speak, that had been defining the degree or strength of its upside momentum.


GOOD TRADING SUCCESS!
 

Trader's Corner Archives