Analysing trend lines

A saying which you will hear time and again in charting and technical analysis circles is: "the trend is your friend".  What we mean by this is that the use of trend lines is one of the basic tenets of charting and one of the most reliable.  When a trend is in force, one is well advised to follow it.  When a change to that trend occurs it tells you that the force that was driving the trend for that particular period of time has now changed and a new influence is affecting the share price.  It does not necessarily mean that the price will immediately move in the opposite direction, although sometimes it does, but that a change of some kind is occurring.

Trends can be drawn over any time frame including over days, months and years and even down to the minutes throughout the day.  To find a trend, one must be able to identify a series of rising peaks and troughs in an uptrend and a series of falling peaks and troughs in a downtrend, and to draw a trend line one must be able to find at least three points which touch a straight line. Following a trend and changing your position on a break in that trend can be a successful way of trading and investing.  This may seem a simplistic trading method and it is, but if we wish to do so we can add some layers of sophistication to our use of trend lines.

The way in which prices move within their trends, allows us to employ more techniques. One of these is the trend channel.  Quite often when following a trend you will find that prices move a certain distance away from the trend and then the price turns and appears to be drawn back to the base trend line in an almost magnetic fashion. This kind of movement away from and back towards the trend allows us to draw another line, parallel to our original trend which acts as a guide line going forward, allowing us to anticipate the wave like motion which affects prices.

If we follow the All Ordinaries index between 2003 and 2006 it moved within a well defined upward channel without a break in the trend.  We were given a buy signal as the previous downtrend was broken and the new upswing began, but we would not have been given a sell signal through a breakdown of the trend over this period of time.

For traders who may not wish to hold a position for this length of time, they may use the waves within the channel as a guide.  The optimum time to buy would be when the market has moved back to and reaffirmed its base trend line and the optimum time to sell would be when the upper limits to the trend channel have been reached and prices turn down.

However, we must always be alert to the potential for change within the trend channel.  Sometimes a spurt of momentum can force prices outside of its "comfort zone" within the channel. So it is important not to move to early and wait for the deflection from the channel line. If we continue our analysis of the All Ordinaries we find that just such a spurt of momentum has forced prices outside of its normal path four times from mid 2006. The longer and higher that prices move outside the channel, the more dramatic and deeper is the return to the channel.  What we must consider is whether the structure of the trend channel is changing and perhaps new guidelines need to be drawn.

What may be happening is that the momentum driving this particular trend has found a new benchmark which has the ability to expand the channel and allow for greater movements away from the base line.  However, as past experience has proven, if the market drops back beneath its upper benchmark then prices are likely to fall back into their comfort zone and traders and investors should use this as a guide for changing their positions.

About the author

Regina Meani has over 29 years experience in the stock market, working as a chart and technical analyst for Deutsche Bank and Huntleys' before freelancing.  She has lectured for the Securities Institute of Australia, Sydney University and the ASX and written Charting, An Australian Investor's Guide. Regina is a Certified Financial Technician and a member of the ATAA and is vice-president of the Australian Professional Technical Analysts (APTA). She has a regular column in the Sun Herald Investor and the Melbourne Sunday Age and in the AFR Smart Investor magazine.

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