Trading BSE Stocks using Trendlines
Technical analysis is built on the assumption that stock prices trend. Trend Lines are an important tool in technical analysis for both trend identification and confirmation. A trend line is a straight line that connects two or more price points and then extends into the future to act as a line of support or resistance.
First Some History Using trend lines as a tool to technically analyze the markets has been around for a long time and was originally also used by floor traders. They saw that 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 ups and downs along the line but you should still be able to discern a general direction up, down, or sideways. |
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How to draw a trend line.
The first consideration when looking at any market is the direction of the long term trend.
Trendlines illustrate the direction of the market movement and provide a primary consideration in any analysis. Keeping in mind that the market can move inmore than one direction the following applies when drawing a trend line:
Uptrends consist of a series of successively higher highs and lows.
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.
Downtrends consist of a series of successively lower highs and lows.
Drawing trendlines in a down trending market: Down trending trendlines are drawn by connecting as many successive highs as possible as shown above (along the top of the price range). A down trending trendline represents major resistance for prices as long as it is not violated.
Support and Resistance An important concept in the use of trendlines as mentioned above is that of support and resistance. A continued trend is based on underlying support for prices in the market, for whatever reason. Similarly, there is resistance to higher prices built into the market. The trendline is one
way to capture and illustrate these zones of support and resistance. |
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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 general idea behind trading trendlines is to look for a break of the trend in the opposite direction.
A perfect set up would be for the market to break through an established trendline A-B as illustrated below. You could add Bollinger Bands and wait for price to also break through the middle line of the Bollinger Band at Point C before placing your trade..
Below is a 4 hour chart of the BSE Sensex:
Advanced
A more advanced method is to use the break of the trendline A-B as confirmation
of the overall trend change, then wait for price to hit point C (Purple
Arrow) and then use the Commodity Channel Index (CCI) indicator to reaffirm
the trade.
Trading rules:
- Wait for price to break the trendline A-B.
- Place your trade when price hits the middle Bollinger Band line at Point C (Purple Arrow), but only if the CCI shows a cross above 100 as at Point E illustrated on the chart below.
- Exit the trade when price hits the upper Bollinger Band line at Point D (Yellow Arrow).
- Your stop is the first close of a candle below the lower Bollinger Band line.
Daily chart of the BSE Sensex with the Commodity Channel Index indicator (CCI) set at 34:
Conclusion
Trend lines can offer great insight, but if used improperly, they can also produce false signals. Other items - such as horizontal support and resistance levels or peak-and-trough analysis - should be employed to validate trend line breaks. While trend lines have become a very popular aspect of technical analysis, they are merely one tool for establishing, analyzing, and confirming a trend.
Trend lines should not be the final arbiter, but should serve merely as a warning that a change in trend may be imminent. By using trend line breaks for warnings, investors and traders can pay closer attention to other confirming signals for a potential change in trend.
Thank you for joining us in this stock trading lesson.
The Indiadaytrading Team
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Information, charts or examples contained in this lesson are for illustration and educational purposes only. It should not be considered as advice or a recommendation to buy or sell any security or financial instrument.