I'm always happy to cover questions or topics suggested by our Subscribers but unless I get other questions that would be useful to address in this forum, I am going to repeat my basic technical analysis article series I last did a few years back. That series was sort of my (Essential Technical Analysis) book only in bite sized chunks. One goal is to place this series into our Trader's Corner archive, so it would be available to all and I could refer to a particular article when a topic comes up that relates to it.

Please e-mail me when you want other, more specialized or advanced topics covered and I'll add a response in this space if of possible general interest. In any case, you'll hear back from me directly.

By the way, my approach to the markets is not to 'rigidly' apply technical analysis only to trading options on stocks and indexes. I certainly look at earnings, economic conditions and all that. It's just that I found many years back that technical analysis was, for the most part, the only way I was not misled in overstaying in a trend that was failing or reversing. Getting in EARLY in a solid trend was the other invaluable contribution I gained from studying charts and indicators.

All of my study of this subject would have been of still limited use except for happening into a situation where a phenomenal private Wall Street trader took me under his wing to mentor me on this subject. This was an ego trip no doubt as I he got a soapbox and an audience of one, always ready to listen to ALL he expounded and he loved to talk. My own business suffered for a few months, but my understanding of the market grew tremendously. It was because of this opportunity that I eventually became a PaineWebber (now UBS) technical analyst and fund manager.

Before I launch into my first article on trendlines and speaking of Subscriber questions...

SUBSCRIBER MAIL:

In response to some writing and research I was doing with the CBOE S&P 500 Volatility Index (VIX), I got this mail:

"Forget the VIX. The old tried and true word of the market sage is "sell in May and go away".... a pragmatic approach only exceeded by Act 1, Scene 1 of Macbeth when the three witches are contemplating the future...."

Well, I did note in my last (4/17) Index Wrap that the VIX, on its last dip below 5% of its 10-day moving average, if not suggesting a possible top, AT LEAST suggested that we might start to get more two-sided trading swings and that seems to be happening, witness today's price action. See my current VIX chart set up below:

One other query I got in reference to my Trader's Corner of earlier this week on the basics of candlestick charting. I made the statement that: "Any real (candle) body that is not filled in ('hollow') indicates that the close was HIGHER than the Open. When the Close is BELOW the opening price, that candlestick has a real body that is filled in with a color."

Well, the 'hollow' body concept was negated by one candlestick chart I showed, which certainly didn't have any 'hollow' body that was NOT filled in with a color, per my next chart of SPX.

The term 'hollow' goes back to original Japanese candlestick charting which was in pen and ink. With present day charting applications you can fill in the so-called hollow body (that term still applies to the fat body of candles that have a Close greater than the Open) with a color; I happen to use dark green, designating an up day in candlestick terms, dark red designating the days when the Close was below the Open.

The foregoing chart is a good segue into my main topic of TRENDLINES. In the chart above, there are two parallel trendlines but only the lower, fatter, trendline is an UP trendline, consisting initially of a straight line connecting the lows of 2/5 and 2/25. Two points consist of the minimum number of lows (or highs) to construct a trendline. Better is to have 3 or more such points. Later, a 3rd low (4/16) touched the up trendline. An intraday low the following day (4/17), fell under this trendline, but the Close was above it, making the lower (cyan) up trendline still 'valid' so to speak. More on this later.

BASICS OF TRENDLINE/TRENDLINE ANALYSIS:

Trendlines are one of the most basic and useful technical analysis tools in assessing trends and possible trend reversals in stocks, stock indexes and other financial instruments like bonds, currencies, etc. In fact the world wide trade in currencies relies, more than in stocks, on technical analysis, which is a discipline that doesn't rely on spoken languages and reports.

A trendline is, as the name implies, a line that attempts to measure and define a price trend in any market that involves prices set by the free actions of buyers and sellers; e.g., the fed funds rate is not such a 'free' market.

A trendline is also by definition a line that either slopes up or down to some degree in keeping with the primary definition of a trend as meaning having a predominantly up or down price direction. Parallel lines that are drawn across the highs and lows of a sideways trend or a trading range are usually referred to simply as 'horizontal' lines.

A (I'm tempted to say 'the') basic technique of charting is the use of trendlines. However, not all trendlines are drawn the same way. There is not just ONE correct way to construct trendlines. I tend to be a bit creative in the construction of trendlines in that I will use a type of construction that could be called 'best fit' analysis or can be called internal trendlines.

A conventional trendline, or what we learn in charting 101, is to draw an initial trendline through the 2 or more (preferably a minimum of 3 points) highest highs or lowest lows on a bar, candlestick or line (close-only) chart. An internal trendline draws a line through the MOST number of highs or lows; more on this shortly.

A rising or up trendline is usually drawn by connecting 2 or more, 3 or more if available, lows. You can start with two lows as was the case in the up trendline seen above with my SPX chart seen above. The resulting line will then, more often than not, BELOW the level of the other periodic price drops that occur in a rising trend; other names: 'dips', 'pullbacks', 'corrections', 'reactions', as in for every action there is some re-action, such as caused by sellers who think a stock is overvalued, even if only temporarily.

What really defines a rising up trendline is not the advancing price moves or price swings, but the low point of the downswings, dips or pullbacks on the way up. You hear the saying 'buy dips' or buy weakness. This generally refers to buying the price declines in a rising trend or as it often turns out, buying pullbacks that touch or are near an up trendline. Downside reactions in an uptrend will usually stop above, at or near a rising up trendline.

The chart below, taken from my book illustration illustrates a simple up trendline and connects 3 or more intraday lows – you never have to search very far for examples of trendlines. This one is historic but you can find trendlines like this often in price charts. You only have to start drawing them, and re-drawing them.

A down trendline slopes down obviously, measuring a falling price trend and is typically drawn by connecting two or more, three or more if available, of the highest highs of the periodic upswings or rallies that occur in a declining trend. The points that establish the down trendline are the high points or peaks of the upswings; i.e., minor rallies that run counter to the general downward slide in prices.

The advice to 'sell rallies' is typically in reference to a declining trend and a rebound to the down trendline would be a good way to do it as there are usually some countertrend price rebounds, unless in a very sharp 'waterfall' type decline. In a decline, trendlines that slope down in a very steep manner are more common than those that have a radically steep upward slope. As we know, bear markets can be brutal. Rallies in a downtrend will usually stop below, at or near a falling down trendline.

Trendline resistance is the expected selling that tends to develop on rallies that carry up to a down trendline. The chart below is a line chart that 'touches' or connects 3 or more closing lows.

The downtrend above is best 'defined' on the 3rd touch in the down trendline (Feb); note the steep drop after that. A downtrend was then in effect until May, when (on a closing basis) there was a rally to above the dominant down trendline.

Note that the rebound from the resistance trendline on the lower right of the chart illustrates the principal that support and resistance trendlines can assume also opposite roles at a later stage; the above resistance trendline, once broken, later defines an area where this unnamed stock found buyer interest, what we call so often, a 'support' area.

This brings me to the question of which chart type to use and does it make a difference? Generally it doesn't matter whether you use a bar (or candlestick) or line chart, assuming you have enough points to construct a trendline. Using a standard bar chart of candlestick, close-only, Pt. and Fig., in terms of whether one is 'better' than the other. Different chart types, as well as time frames, will tell you different things sometimes.

A pullback in an uptrend may dip under the trendline that uses the lows, but not be apparent on a close-only line chart. I tend to prefer drawing trendlines on daily bar charts. For weekly and monthly charts, I generally draw a line first with a bar chart, than switch to a line or close-only chart for comparison. If the line chart gives me a clearer trendline definition I save and use that one.

You can also draw trendlines on Point & Figure charts, which makes a third choice as can be seen in the chart below, that of the S&P 500 (SPX) Index. The upside penetration of the down or resistance trendline at the extreme right suggests a trend reversal from down to up.

Next are some charts that include descriptions related to methods and points related to trendline construction. Because the use of trendlines is often more 'art' than a 'science', traders can get frustrated when the so-called trendline 'rules' don't seem to work. Also, there is the fact that it takes some months and years to see how trendlines work in a variety of stocks and market conditions.

Conventional or traditional trendlines are straight lines drawn through at least two lows or highs, preferably three, and such a trendline never bisects or 'cuts through' any bar (the price range for that period), candle, etc.

I look at trendlines as angular measures of price MOMENTUM and what force or 'momentum' has developed is not always precisely defined. If so, that's a case for a trendline that could cut through some of the bars on a chart as I'll demonstrate. Such trendlines are simple 'best fit' trendlines, lines that are drawn touching the greatest number of highs and lows. This line visually shows rate-of-change or price momentum, visually depicting the dominant momentum of the trend.

Trendlines that go through the MOST number of high and low points, and I sometimes count them up, reduce the subjective judgment as to what is the best way ('best fit') to draw the trendline. These type of process was to my knowledge first called internal trendlines by Jack Schwager, a technical analyst and writer in this field.

Although there is more than one way to draw a trendline, the guidelines for best USE of trendlines are highlighted in my concluding charts.

The guidelines for using trendlines regardless of how they are precisely constructed, is to buy on declines to or near a support (up) trendline and sell rallies that touch or approach a resistance (down) trendline. A decline that goes through (breaks) an up trendline is an indication that the trend has reversed and a shorting/put buy strategy is suggested.

A rally that goes through (breaks out above) a down trendline is an indication that the trend has reversed and a buy/long call, bullish strategy, is called for; certainly until the stock or the market does something different. A value in buying just AT the trendline breakout is that the right place for your stop or exit point for the trade is just under the trendline and close to your entry. Risk, relative to a large upside potential implied by the trendline breakout (reward), is in good balance.

My next piece in this series will more on effective uses of trendlines, followed by laying out the very important trend channel concept and the benefit of tracking such patterns whenever they develop.


GOOD TRADING SUCCESS!