Trend Lines
With all the fundamental analysis that you can apply to a stock there should also be room in your decision making process for the charts. Most people are use to the concept of identifying either Bullish or Bearish sentiment very easily by the application of a trend line. We have mentioned trend lines several times in previous articles and it is prudent to examine them in more detail and understand a little more of what they can indicate.
Bearish Trend lines:
Drawn from peak to peak during a bearish (down) period, either from the extreme points or from the most touches.
Bullish Trend lines
Drawn from trough to trough for bullish (up) periods, either from the extreme points or from the most touches.
Validity
The degree of importance assigned to a trend line is dependant upon :
- the length of time, and
- steepness of the angle
Trend lines with longer time periods are normally accompanied by increased levels of price action touching or bouncing off the trend line, ever-strengthening the validity of the trend line.
As a general rule of thumb, the steeper the angle the less relevant the trend line. Technical analysis argues the sharpness of the angle indicates the depth of market sentiment at that time. Short-term trend lines have more acute angles depending upon market enthusiasm and/or a change in the underlying fundamental analysis of the instrument. i.e. - oil discovery for an oil stock or interest rate differentials for forex. Over time, the level of sentiment will revert to the long-tern norm of a trend line.
How to Use the Trend Line?
Broadly speaking, the trend line indicates whether the instrument being traded (stock, index, forex) is either bullish or bearish. For the trader, a 'long' trading opportunity is signalled if the price action for the instrument bounces off an existing bullish trend line. In effect, the price action is bouncing off support. On the flip side, if the price action breaks down through the bullish trend line, this suggests the possibility of a 'short' trade opportunity (subject to confirmation).
For a bearish trend line, if the price action fails at the downward sloping trend line (hits resistance at the bearish trend line), this signal a possible shorting opportunity or if the price action breaks up through the bearish trend line, this signals a potential 'long' opportunity.
Further confirmation of the trade potential is implied when a break or a bounce of the trend line is accompanied by an increase in trading volume.
Risk Management:
All trend lines will break over time. Employing stop loss levels will depend upon the trader's risk tolerance and the steepness of the trend line. Generically speaking, the more valid the trend line, the wider the stop loss.
Example
From the above chart of Aristocrat (ALL), the reliability of the trend line is immediately identifiable.
With an increase in bullishness toward the stock in August 2005, the share price created a new steeper shorter uptrend. Once the underlying sentiment changed, the share price broke through the uptrend to from a new down trend.
Even if the investor/trader was unaware of the overriding change in the fundamental analysis with the ending of the company share buy-back, the break of the upward trend line alerted them to the change in sentiment.
