The first consideration when looking at any market is the direction of the long term trend (with the exception of day traders).
Prices can only go in three directions; up, down, and sideways. A long line of past price ranges together gives you a pattern. There will be plenty of dips and bumps along the line but you should still be able to discern a general direction up, down, or sideways. We can help spot this direction or trend by drawing in "trendlines".
Drawing trendlines during an up trending market: The trendlines above have been drawn by connecting as many successive lows as possible (along the bottom of the price range). An up trending trendline represents major support for prices as long as it is not violated.
Trendlines connecting highs can also be drawn to indicate the top of the established trend or channel (blue lines). These trendlines indicate the major zones of resistance. (See below for a discussion of support& resistance).
Drawing trendlines in a down trending market. Down trending trendlines are drawn by connecting the successive highs.
Trends can push and pull the price up or down. Markets can also enter a period of quiet stability where the price forms a horizontal line sideways across the page. A sideways trending market is normally a difficult market to trade for a profit. It can, however, set the stage for a sharp move once the sideways trend is broken (signalled by a price break through a well-established trendline).
A sideways pattern represents stability between supply and demand in the marketplace. Trendlines in this type of market, often referred to as a narrow trading range or congestive phase, are drawn by connecting both the highs and lows. Prices In this type of market can break upward or downward so it is valuable to establish the top and bottom of the range (see the report on Breakout signals)
An important concept in the use of trendlines is that of support and resistance. A continued trend is based on underlying support for prices in the market, for whatever reason. Similarly, there’s resistance to higher prices built into the market. The trendline is one way to capture and illustrate these zones of support and resistance.
As long as the market stays within these zones of support and resistance, as shown by a trendline, the trend is sustained. Any penetration through a trendline warns of a possible change in trend. We may not know the reason behind such a change, but we do know that for some reason the support or resistance for a market is changing.
The Rhino Theory of Support and Resistance: The upper and lower trendlines contain the price the way a barbed wire fence might contain a rhino. Think of the prices as the rhino and the trendline as a barbed wire fence. If a rhino leans against the wire, the fence will give a bit, offering more and more resistance until either the rhino eases off or the wire snaps. If the rhino has wandered along and leaned against the fence in several places without breaking through, we will have more faith in the strength of the fence.
If the rhino only leaned against the fence once before moving along, it is less meaningful. In charting practice, a line based on one high or one low means nothing. Two highs or lows is the bare minimum. The more points you can connect the more significant the resulting line. And, the more significant the trendline, the more significant any penetration will be. (I say will be because all trends eventually reverse some day!)
Another aspect of resistance and support concerns the round numbers associated with price levels, such as 10, 20, 25, 50, 75 and 100. Since the price reflects the psychology of the marketplace, these levels offer “natural boundaries or targets.” With resistance and support common along these levels, it makes sense to avoid placing orders right at these values. (If buying on a short term dip in an uptrend, you’d place your order just above an important round number). It also makes sense to place stop loss orders below the round numbers on long positions, rather than exactly on the round number (i.e., $4.90 rather than $5.00).
Short term trends are established over a few days. It may be in any direction and has little potential over the long run (except if you’re a daytrader). A strong thrust, however, may indicate the beginning of a move into new ground. Particularly if it crosses a medium or long term trend line. Think of it as an early warning system; a sign to be prepared for a larger move.
Short term trend -- always the current trend. It may not necessarily be in the same direction as the mid or longterm trend.
Medium term trend -- a trend that occurs over weeks to 2 or 3 months. All big moves must start with a short term thrust building to a medium term trend.
Long term trend -- a trend over three months is considered a long term trend. Long term trends show stability.
Any trend which has continued unbroken for over 3 months is considered to be a long term trend, and of some significance. This is the trend to trade with in the majority of cases. It can be thought of as the driving force behind the price and, until a fundamental change occurs in the marketplace, it will continue to do so.
Signals are generated primarily when trendlines are broken. A particularly strong signal is generated any time a long term trendline is broken.
Some traders also use the price “bouncing” off a trendline as a signal. If an upward trendline holds, for example, you may have a buying opportunity at a relatively low price. If the price is in a well-established channel, the other side of the channel can give you an approximate price target.
Also see: Breakout Signals, Reversal Signals, and Triangles.