From the October 01, 2008 issue of Futures Magazine • Subscribe!

Trading with trendlines

When you buy or sell a futures contract, you generally expect to make money by price subsequently rising or falling. The longer and quicker price rises or falls, the more money you make. In the best cases, price continues to make strides in the direction you had planned and your position continues to make money, week in and week out.

These persistent price moves are called trends. Some trends last a week or so, and some trends last several months. A few trends persist for years. There are many explanations for the existence of price trends. One is that they result from commodity prices reflecting slowly evolving economic conditions, which take some time to play out to their conclusions. Another explanation applies Isaac Newton’s First Law of Motion to prices – that is, that an object (prices) in motion tend to stay in motion. Yet another simply states that any time series, even a random one, exhibits extended, seemingly orderly, moves in one direction or another, if the series is given enough time.

Whatever the cause of price trends, they exist. The catch, you might have guessed, is that it’s not always clear when a trend has begun, and its end is usually only clear well after the fact.

Trend traders, though, are not deterred. Trend traders focus their analysis techniques on these extended price moves, believing that the rewards of being on the right side of just one big move are worth being wrong several times (see “When the market moves”). Trend traders generally place long-term trades. They are known for enduring long periods of negative equity in a trade ultimately to capture big moves. Relative to most other types of traders, trend traders are slow to pull the trigger, on either entries or exits.

Trend traders also value simple, direct analysis techniques over complex systems. The best trends, after all, are not complicated; they are clear, steady price moves in a predominant direction. One simple tool is the trendline.

JUST A LINE

Just because there’s a clear price trend doesn’t mean that a trend is tradable. That’s where trendlines are helpful. They quantify the trend and indicate when an entry might be appropriate or an exit might be prudent.

A trendline is a line drawn on a price chart that represents the basic direction of the market. Although technology has offered its own solutions in recent years, with automated trendline software, the vast majority of trendlines are still created manually.

Although variations exist, up trendlines connect price lows and down trendlines connect price highs (see “Spotting the trend”). At a minimum, a trendline should be drawn along three price points. More are better. The trendline is considered more significant the more actual price points the trendline touches.

One mistake that’s easy to make with trendlines — indeed, with all indicators — is to be dazzled by past performance. That is, look to how price reacts to your trendline after the third touch, not before. Of course, it followed the trend nicely before; that’s because you drew the line with past price action in mind. Yes, it’s an elementary caveat, but one that you may have to remind yourself of frequently as you start placing carefully drawn trendlines on price charts and waiting trading session after trading session for the trend to play out — or not.

DRAWING YOUR OWN

Trendlines are quite simple, but there are some considerations you need to be aware of before you start putting lines on a price chart.

The first is direction, not up or down but right to left. Some traders start with the most recent intermediate-term high and draw from right to left. Other traders always draw trendlines off the highest point of the current trend, going from left to right. As we said above, the most significant trend is the one that touches the most price points.

You also need to decide what qualifies as a relevant price. Most traders draw trendlines on a bar chart. They will use the highs and lows of the bars as potential touching points along the trendline. Other traders ignore highs or lows; they may consider extensions above and below the close noise, for example. These traders may only trade off line charts plotted using closing prices and consider intermediate-term extremes in the close exclusively as potential points along a trendline.

There also may be some consideration given to what qualifies as an intermediate-term extreme price. For example, perhaps only days that are preceded and followed by three subsequently lower highs may count as a proper intermediate-term high.

Also, volume may come into play. Volume is a count of the number of transactions that took place in a market during a specified trading session. It is a measure of interest in a particular contract. Some traders may require the touching points along a trendline to occur on high volume. If there wasn’t significant interest on a particular day that session may be ignored completely.

Another more advanced approach to trendlines is based on the work of W.D. Gann. Gann lines, as they’re called, are based not just on price, but time. One central concept involves drawing a 45-degree line (a 1x1) off a high or low. The 1x1 progresses by one price unit for every time unit and represents the long-term trend. The study of Gann lines is vast and beyond the scope of this series, but as a body of work it represents one of the most comprehensive approaches to trend analysis.

There is no right or wrong way to draw a trendline. However, one decision must be made: whether or not to be consistent. While there is an argument for flexibility, it also helps to operate under some semblance of structure. This makes it easier to track your performance more accurately. “Rules for trendlines” (below) shows a rudimentary example of how a trader might quantify trendline construction.

Beyond construction, however, the ultimate decision with trendlines, as with any indicator, is how you will trade them. Some traders draw their trendlines and patiently wait for price to convincingly break the line in the opposite direction as a signal of the start of a new trend and an opportunity to catch a bottom or top. Other traders seek to trade with the trend. That is, they sell during down trendlines and buy during up trendlines, typically reacting to corrections of the dominant trend back toward the line.

Most traders combine both approaches, entering with the trend off corrections and exiting positions, but not establishing new ones, on convincing trendline breaks.

FROM ART TO SCIENCE

Two categories of technical analysis are discretionary and systematic. In general, discretionary traders draw on a collection of honed skills, experience and maybe a bit of instinct, to analyze the markets, perhaps not always the same way day in and day out. Systematic traders codify their analysis so their approach is always consistent

and objective.

While the general practice of drawing trendlines still falls into the discretionary camp, even with the suggested guidelines in place, there have been efforts to make the rules of their construction completely objective and mathematical so they can be applied the same way always.

One tool traders use for consistent calculation is regression analysis. A simple regression line, using time as the independent variable and price as the dependent variable, can be drawn for any number of price points and subsequently extended in the future. With these values known, traders can then test the reaction of price as it approaches these pre-calculated values.

The danger here is the same as it is with hand-drawn trendlines. The analysis is only valid going forward. A common mistake, for example, is to calculate a regression line over a previous downtrend and then judge the performance of that line based on price’s reaction to it in the past.

CONFIRMING THE TREND

For some, even full objectivity is not enough. The strength of the trend must also be confirmed by independent measures regardless of the validity or scientific accuracy of the trendline itself. After all, if the trend is too slow moving to offer a significant return, why bother?

One such measure of trend strength is the Average Directional Movement Index (ADX). The ADX is a popular measure of market trendiness. The higher the ADX reading, the stronger the trend. One way to use the ADX is to combine it with a trendline to identify entry points amid an ongoing trend. If prices turn back toward a moving average line or some other point of resistance, but the ADX continues to climb, it’s often taken as a sign the current trend has the wherewithal to resume.

Another trend-following technique is the Directional Movement Indicator. The DMI generates buy and sell signals when two lines cross. One of the lines measures positive directional movement and the other measures negative directional movement.

The calculation of both of these indicators is rather complex. (See Welles Wilder’s 1978 book “New Concepts in Technical Trading,” where these techniques are introduced, for a full explanation.) They are standard fare in most technical analysis software packages, however, and generally are accessible with a minimum amount of practice.

Still, despite their contribution to the overall study of trend direction, strength and staying power, indicators such as ADX, DMI and objective trendline calculation always come back to just lines on a chart. It’s what you do with those lines, not how you draw or confirm them, that will be the most critical decision you make.

While trendlines can be an effective if simple indicator, the cost of that simplicity is that further work is needed for successful trading. Most trend followers will tell you that there is nothing magical to their indicators, they are fairly universal. They make money based on their exit strategies and risk management once they are in a trend.

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