Going beyond my column of last week on basic trendline construction techniques to the subject of their effective use in making trading decisions. My goal for any technical 'tool' is to help set up profitable trades and right use of trendlines contributes.

CURRENT OUTLOOK QUESTIONS:

I relish covering questions or topics suggested by our Subscribers but unless I get some of these, my contributions in upcoming weeks to this space will be a repeat of my basic technical analysis article series last done a few years ago (2003), especially as this multipart series is not in our current Trader's Corner archives. Without them there, I can't link to some 'basic' market analysis piece on a chart aspect (e.g., trendlines) that adds to the understanding on where we are in the current market cycle.

As always, 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. Most of any mail coming my way this week was in the nature of a 'what did I think"? (of the market) type questions.

The market could be building a top, especially considering the still raving bullish market sentiment that's out there. However this market also hasn't 'broken down' technically. As long as the S&P 500 (SPX) holds above 1180 like its doing, this period looks more like a pause than top.

BASIC TECHNICAL ANALYSIS: EFFECTIVE USE OF TRENDLINES:

As you draw and get familiar with chart trendlines, the construction of which is described in my previous Trader's Corner article (of 4/22/10), you’ll find more occasions where you see and use the 'best fit' trendline technique connecting the MOST number of highs or lows. This technique will cause some extreme highs or low bars to be 'cut' through or bisected. This method of constructing 'internal' or best fit trendlines is different than the conventional understanding of how to draw trendlines.

I made the point in my previous article that, while there are some variations in drawing trendlines, 'use' guidelines are mostly the same. This is point #1.

Point # 2: trendlines are, in effect, 'angular measures of momentum', shown visually on a price chart. If you remember this point on the nature of what trendlines are, you will also recognize that a rate of momentum is a quality of the trend that is sometimes hard to measure exactly. So, trendlines are not always exactly precise either.

CHART EXAMPLES ARE TAKEN FROM MY BOOK FOR ILLUSTRATION OF THE CHARTING PRINCIPLE INVOLVED.

Trendlines show in effect the 'rate of change' for prices in an up or down direction as expressed with an angular line. If prices are going up an average of 3 percent a month, this mathematical progression can be shown as a straight line that angles up to the right.

However, drawing trendlines must also take into account the extreme highs and lows (above or below the 'mean' or average rate of change) or emotional points of excess in the market. Given this reality we can expect that there will be some false 'signals' given by trendline breaks and breakouts; i.e., downside or upside penetrations of the line drawn as a trendline. Points of 'excess' go further than is normally predictable; just as has been true lately of longer than normal periods of extreme bullishness.

You can anticipate that you will need to periodically or even frequently re-draw trendlines to account for some new extremes if you want the most accurate visual depiction of the trend momentum. There is the axiom in technical analysis, like many disciplines, that you must put in time and work if you expect rewards from the technique. The money or risk management rule about always limiting losses will help protect you in the times that trendlines don't 'work' so to speak; times when the trendline you've constructed fails to identify the exact parameters of a trend or trend reversal.

Getting in early on trends, for which trendlines will be of considerable help, provides the best opportunity for capturing the most profit from a trend. Accomplishing this objective more often than not tends to make up for periodic losses along the way. The idea is to keep using trendlines. They will 'work' over time as a forecasting tool but you need to also keep using them to gain experience. You'll also learn to not expect more than the tool can provide.

Point #3 on trendlines: trendlines look like they make identifying every trend and trend reversal easy AFTER the fact. Once price action has unfolded it's easy to see the dominant trendlines apparent in the next charts.

I have some further discussion later on the need to re-draw trendlines, especially in the beginning of new trends.

THE FOLLOW ON CHART STORY (TO THE CHART ABOVE) IS BELOW:

The downside price action shown circled above did NOT take out the prior downswing low on two back-to-back days. I often indicate that if a new closing low lacks downside follow through on the SECOND trading day, it may be a false 'signal' in terms of forecasting further weakness.

The sideways consolidation above in AA, which is really that of a rectangle, was merely a pause in the trend before a next up leg. Trendlines are not the sole technical tool that we would need to use to profit from the trend shown above.

Of course, the break of Trendline T3 above was fine as an exit point to stand aside awaiting a next move in the stock. After a next rally became apparent especially by the breakout above the down trendline (sloping down from point 'T3'), re-entry could have been made to participate in the further run up.

ANOTHER CHART STORY:

Just as a prior support, once pierced, tends to 'become' resistance later on and vice versa with upside breakouts becoming support later on, the same is seen with trendlines. A support trendline, once pierced, tends to become a point of resistance later on as is seen at points 'T1' and 'T2':

NEXT: THE 'LOOK BACK' CHART FOR THE SAME STOCK SEEN ABOVE

Assuming an exit from being long this stock/long calls, based on the trendline breaks seen above, there is a next piece of history to follow. From the $8 to 10 areas the stock went on to have quite a run. There was a lot more upside and further rising bullish trendlines to come!

AND, STILL LATER:

It takes some time to make nearly as good of use of trendlines going forward, as it is from looking BACKWARDS. When market action is unfolding and you are in a stock or index that you identified as having begun an uptrend (perhaps due to a breakout above a down trendline), along come points where it’s hard to figure how to draw or redraw a trendline. And, they do need to be adjusted as market action unfolds.

Some technicians will apply a rule that a trendline must be penetrated by a certain percentage or dollar amount to 'confirm' the penetration. Then there is the question of whether to draw a trendline through an apparent extreme (cutting through a bar) or not.

There is also the risk that placing a stop under a trendline will result in exiting a position because prices dipped under the line, then resumed an upward course. For this reason, exiting only on a close above or below the trendline, depending on whether you have bullish or bearish positions on, could be a method employed to try and confirm that a trend reversal has in fact occurred. This strategy in turn has a risk of losing big if the day is hugely down.

Point #4 on trendlines: trendline breaks often lead to some outstanding trading and investing opportunities later on if you only continue to keep track of the previously broken trendline. This point relates to the idea of a support trendline, once broken, 'becoming' a line of resistance later on as seen in a startling way in AA on the run up to the 43 area.

The last point, #5, which was already touched on somewhat, is that trendlines frequently have to be re-drawn, especially in the beginning stages of a new trend as demonstrated in the chart below:

An upside or downside penetration of a trendline, especially in the early part of a trend, does not necessarily negate the emerging trend or confirm a trend reversal. Prices may be undergoing a sideways consolidation or only a minor correction in the initial formation of a trend, so final definition for a trendline can take some time to complete itself.

Within an emerging uptrend, one key to what is going on with a correction is whether a current decline stops at a point above its prior low. If it has not, simply redraw the trendline from the lowest low through the bottom of this newest low. The reverse is true in an emerging downtrend: redraw the down trendline through any new higher high.

It is rarer to have to as frequently redraw a down trendline, as declines are often more steep to begin with and often don't get less steep for quite a while. This goes back to the nature of bear market trends and he fact that a lot of selling tends to come in all at once: a one-time decision is often the case for long liquidation, whereas buying is phased in typically by both individuals and institutions in the stock market.


GOOD TRADING SUCCESS!