Mastering Trend Lines and Support/Resistance Levels in Technical Analysis
A trend line defines the trend. For instance, if I'm in a long position, I would maintain it as long as the stock remains above the trend line. If I'm in a short position, I would maintain it as long as the stock continues to drop below the trend line.
To draw a trend line, you need at least two points. If a stock price is declining and possibly beginning a trend change, you would need two points to attempt drawing an upward trend line. With only two points, the line is under trial—it's not a line you'd want to rely on as it might be random. The line becomes valid at point 3. In other words, you've speculated using points 1 and 2, and the market confirms that your speculation is correct. This confirmation makes the line valid.
[Refer to Chart 1].
Chart 1:
How to Use a Trend Line:
A trend line defines the trend. It allows you to trade in the direction of the trend. For instance, if I'm in a long position, I would maintain it as long as the stock remains above the trend line. If I'm in a short position, I would maintain it as long as the stock continues to drop below the trend line.
A trend line can be helpful for short-term trading. You could buy at the bottom (for example at point 1), sell at the peak, then buy again at the low point, and sell at the high point.
The longer a trend line lasts and/or the more it withstands breakout tests, the more reliable it becomes.
You can use the trend line to stagger entry into a position. For example, you could enter 25% at point 3, then add another 25% at point 4.
However, when a trend line breaks, it's an indication of a trend change. Why? The line characterizes the balance of power, and a break characterizes a change in the balance of power. The cause doesn't interest us. A breakout of a trend line requires a change in our strategy. For example, if we had 100 shares, we could sell 200, thereby closing the position and starting to profit. This action is called SAR (Stop And Reverse). However, it's risky as if we are wrong, we not only have to revert to the position but also suffer losses from the short. Another option is to close the position and enter into a short position later after verifying and confirming the new trend line.
Understanding a Reliable Breakout of a Trend Line
We need to define upfront what we consider a breakout threshold; we won't be able to act accordingly otherwise. The choice of the breakout threshold depends on:
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Each person's trading character – If I'm an aggressive short-term trader, I can't wait long and will choose smaller filters and breakout thresholds. The price will be more SAR actions. If I'm a long-term trader, I'll choose thicker filters. The advantage – the thicker the filters I choose, the less noisy SAR will be.
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The volatility of the stock – The more volatile the stock, the more I'll be exposed to noise if I take thin and close filters. Everywhere the trend line breaks, it is subject to the filter we set. If the trend line was a short-term trend line, if a short-term trend line is broken, the change's significance is primarily short-term.
Everywhere the trend line breaks, it is subject to the filter we set. If the trend line was a short-term trend line, if a short-term trend line is broken, the change's significance is primarily short-term.
Slope
A very steep trend line represents very sharp price changes, and there's a chance it will break towards a more moderate line.
A very moderate trend line is considered weak, and therefore there's a good chance a steep line will break it.
A broken steep line doesn't mean a trend change but possibly a transition to a more moderate line. Breaking a moderate line means a trend change.
Long/Short Range
In technical literature, the short term is defined as one to two weeks, the medium short term as two weeks to a month, the medium term as a month to three months, the long medium term as 3-6 months, and the long term as half a year and above. However, as time passes, these ranges shorten. Markets have become faster and more volatile, with their response speed increasing. The classic definitions of ranges found in books are getting shorter.
Return Line
A line parallel to the trend line. A return line connects, as much as possible, the peaks of the rising waves or the troughs of the falling waves. It's more difficult to find a precise and regular sequence in return lines. The higher accuracy is in the area of the trend line and less good in the area of the return line.
The return line serves:
For trading – If you manage to find a stock with a return line, buy at the trend line, sell at the return line. This is called a trend sleeve.
For power signals – Breaking a trend line indicates a trend change, breaking a return line indicates a strengthening of the trend, and often, a more steep trend sleeve is expected.
When a stock fails to reach the return line, it's a sign of weakness. The stock couldn't progress, climb as it did in previous times, and if a trend break is also added to this, it's already the second sign of weakness, unlike a situation of only a trend line break. In the first case, we respond faster.
Support and Resistance Levels
Support level: A price level where the decline of a stock is expected to stop at least for the short term.
Resistance level: A price level where the rise of a stock is expected to stop at least for the short term.
Why are there support and resistance levels?
The reason for the existence of support and resistance levels is purely psychological, there is no economic meaning in it. For example, in the chart before us, whoever remembers Amazon at $60 rose to $110 and is waiting for it to return to $60 to buy again. [Chart 2]. This means that there are people waiting to buy the stock at $60, which means that at least for a short period, there will be buyers who will provide at least short-term support to the stock at this level.
The same applies to the resistance level. A support/resistance level is merely a point of balance from which we can know what is happening to the stock – either the stock will start to rise or the opposite. If you see that the support is working, it's a buying signal for a rise. If the support level is broken downwards, the sellers came out stronger. A reliable break from a support level is a fairly reliable sign that the stock will continue to fall, a break from the resistance line is a fairly reliable sign that the stock will continue to rise.
Please note, for example, in the chart – a situation of $61 is a sign of purchase, and $59 is a sign of sale, although it contradicts economic logic.
Chart 2:
Breakouts during the trading day
If you trade according to the line chart, and I am not a Day Trader, look at the end, the closing price is important. A picture of a stock during the day can be completely different from the trading picture at the end of the day.
