Tips on using trend-lines to trade forex




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Tips on using trend-lines to trade forexTips on using trend-lines to trade Forex

One of the principles underpinning the use of technical analysis is that the prices in financial markets move in trends. To illustrate this technicians draw trend-lines on charts to reflect the direction of the underlying trend. An example is shown in the chart of euro-yen below which is trending up and has an up-trend line drawn in black on it.

Trend-lines act as important areas of support and resistance. For example, in a bull market falling prices will often stop at a trend-line and find support there because buyers start to buy expecting prices to recover and the trend to continue. Likewise rising prices in a bear market will oftentimes meet resistance at a trend-line and usually stop at that level before resuming their down-trend. This is also illustrated in the chart above which shows how the trend-line acts as a support level several times, first on August 3 rd. then on August 13 th and then again on September 5 th .

Trend-lines can change their roles over time, starting out as levels of support in an uptrend but then after being broken changing to levels of resistance. This is why experienced technicians often do not remove old trend-lines from their charts even after they have been broken.

This duality is illustrated in the diagram below which shows a trend-line drawn on a 4-hour chart of Eurodollar, which initially operates in a traditional way as a support level but is then broken at the end of October and becomes a resistance level at the point marked ‘X’ in the top right hand part of the chart, when there is a throwback after the break of trend.

How to Draw Trend-lines

A proper trend-line has to connect two or more peaks or troughs; otherwise it will be drawn in space and will have no significance.

One other important consideration is that the trend-line should as far as possible reflect the underlying trend. There is no point in connecting two troughs if they do not really reflect the trend.

The diagram below illustrates this problem. The price is rising in a series of peaks and troughs. The trend-line for this rally could be drawn as either A or B – both are valid from a purely technical standpoint, but from a reflecting the underlying trend standpoint then A is more accurate than B and so should be used in preference to B.

Corrective Fan Principle

When a trend-line is broken and a new trend-line is drawn at the point of the new peak or trough it shows deterioration in the strength of the trend. If this happens three times then according to the ‘Corrective Fan Principle’ it signals the end of the trend. This is a useful rule to use to determine when a trend may have completed and a new trend is beginning.

This principle is clearly shown on a chart of EUR/USD below. The chart shows a new uptrend beginning in June 2010 and a trend-line is drawn to reflect this. The trend-line is broken, however, by the correction in November 2011 and a new trend-line is drawn – No 2. Finally this trend-line is broken in July 2011 and trend-line No 3 is drawn. This is finally broken at the beginning of September 2011, at which point it could be argued the trend has died and a new down-trend has begun instead.

Best Indicators to combine with

Trend-lines work best when combined with other technical analysis tools. The use of horizontal support and resistance lines, for example, can be particularly fruitful as it provides a sort of ‘grid’ of support and resistance levels off which the price often bounces.

Trend-lines work particularly well in conjunction with price patterns too, especially when it comes to reinforcing trend-line breaks and signalling reversals of the trend. The combination of a break of trend-line and at the same time a break of the neckline of a double top or Head and Shoulders pattern provides a strong signal to take action.

In the chart below the combination of resistance from a down-sloping trend-line ‘A’ and the triangular price pattern signals the probability of a reversal in trend when the trend-line ‘B’ is broken at point ‘C’.

Another technique which works well with Trend-lines is Japanese candlestick analysis. which can give useful clues as to how price will react when it reaches a trend-line. For example, it a hammer forms on a trend-line then it is likely that the trend-line will act as support and lead to a bounce, if however, the price action simply continues through the trend-line without forming any kind of reversal candlestick then it is more likely that a trend-line break is in progress.

The chart above shows how well candlesticks can work with trend-lines to illuminate areas of support or resistance. Points a, b, c and d show candlestick pattern which lie on or close to the trend-line. Patterns a, b and d are hammer candlesticks whilst c shows a bullish engulfing. They all lead to recovery moves and a continuation of the uptrend.

Hopefully this article has been useful in highlighting how a simple technique can be used to great effect. The modest trend-line is one such tool which despite being rather old-fashioned nevertheless continues to prove it is a classic in both its continued utility as well as its beauty and simplicity.