The trendline is a downward or upward sloping line drawn by connecting two or more swing high or low.
Used to trade along with the trend or even to trade breakouts.
Fake breakouts from trendlines can happen due to no proper shift in momentum.
What are trendlines?
To put it in simple words, trendlines are basic tools that allow traders to connect two or more points on the chart with a line.
Once you plot a trendline, you'll see that the price actually bounces from this and this gives you trading opportunities.
Imagine it like throwing a basketball or any other ball down a flight of stairs, what do you see?
You will see that the ball bounces from the steps and keeps going further.
In trendlines, we have two types of trendlines on basis of its sloping, an upward sloping trendline and a downward sloping trendline.
The upward sloping trendline is a bullish one and the downward sloping trendline is a bearish one.
The most basic use of a trendline would be as a sloping support and resistance line.
If price is in an uptrend and if you connect the swing lows then you get a bullish trendline and you will be surprised to see that price often tends to respect such lines.
Also, if you connect swing highs in a downtrend then you get a bearish trendline which is also respected by price.
So, trendlines are used to establish trend direction, but is that all? No. Trendlines are also used to connect price points to form patterns which in turn provides trading opportunities to traders.
What is the psychology behind trendlines?
I am sure that by now you know what trendlines are and how they are plotted on price charts.
Let’s dive into another important aspect of trendlines, the psychology behind them. This is very important yet often ignored, unfortunately.
Let’s consider the price chart or EURUSD. You see that the price is in a downtrend and to establish this you connect the swing highs to form a downward sloping trendline.
If the price is in a downtrend it means that the sellers are in control and are actively selling, but will this go on forever? No.
There will be times when sellers will get out of the market by booking profits and the price will correct a little bit.
Do you remember the impulse and correction concept? It will be nice if you related it here.
As price corrects it is now available at a better price for the sellers that are still present in the market, so they add to their position.
While the price is correcting, there will also be fresh buyers that enter the market thinking that the trend is going to reverse and that the sellers are getting weak. But we can’t say what will happen yet.
In order to establish a trend reversal, we need the trendline to break and if it doesn’t then we know that the buyers haven’t really gained strength and that sellers are still outnumbered.
This cycle may repeat multiple times and there will be a moment in the market where all sellers are dried up and eventually buyers will rise up and take the price up.
Price would then go on to break the trendline and we will see a trend reversal.
All that we discussed in the downtrend will happen again in this newly formed uptrend and it is all just a normal process in the markets.
The financial markets are all about human psychology and sentiment and the changing of the hands of sellers and buyers.
There are people buying and selling everywhere but in order for price to move, one particular side has to overpower the other.
An upward sloping trendline indicates that the momentum and trend are in favor of the buyers and that they are in control at the moment.
But will it always stay like this? No, not always.
There will come a moment where the buyers will get completely exhausted and they will lose control to the sellers.
The same is the case in a downtrend. Sellers are not going to stay in control forever and buyers will take control eventually.
This does not mean that the buyers or sellers lost, it is a basic market phenomenon and it happens all the time. This is what keeps the price moving.
We have seen that as the price keeps respecting the trendline, more and more participants of the prevailing trend keep adding up.
Once there is a break of trendline it indicates that the gap between the market participants has now been covered and that the trend has reversed.
How to effectively identify break of trendline and trend reversal?
In an uptrend, while the price is respecting an upward sloping trendline, a break of trendline would be when the price closes below the trendline.
In a downtrend, a break of the trendline would be when the price closes above the trendline.
This is all basic knowledge, but do you want to know an even more effective way to identify trend reversal?
We know that when the price is in an uptrend, it forms a series of higher highs and higher lows, while in a downtrend it forms a series of lower lows and lower highs.
A trend reversal is established beyond doubt when the price goes from forming higher highs higher lows to forming lower lows lower highs and also when it was forming lower lows lower highs to now forming higher highs higher lows.
Now, whenever you spot a break of trendline, try and look for this price action too. This will give you double confirmation for trend reversal and the trades that you take further will have a higher probability of playing out as you plan.
How to avoid fake breakouts in trendline trading?
Fake breakouts are very frustrating, I have been there many times and I won’t deny that it doesn’t feel good. In trendline trading especially, fake breakouts happen often.
Price will shoot out of the trendline making it seem like a trendline breakout only to again fall back inside the trendline.
So is there anything that you can do to avoid falling for such price movements? Yes of course.
1. Look for a proper shift in momentum
The markets are all about changing hands between buyers and sellers and this is the very thing that keeps the price moving.
I already told you that trendlines are broken only when the momentum changes and only then will the trend reverse.
Even if the price breaks a trendline, you shouldn’t jump right into the trade. You must look for any support or resistance level that lies in the path of the price that could be a hindrance.
For instance, you are tracking the USDCAD currency pair and you see that the price is respecting an upward sloping trendline.
You spot a trendline break to the downside but you also see that there is a support level very close to it. You should wait for the price to break this support level too.
The same would be the case if you see a break to the upside of a downward-sloping trendline.
The reason for this is that support and resistance levels are strong value areas on the charts that can influence price greatly.
Even if the price breaks the trendline and ends up on the support or resistance level, it could bounce away from these levels and fall back into the trendline.
This would then be a classic example of a fake breakout and if you entered on the break of the trendline then you will be in a losing position.
Hence, you have to look for a proper shift in momentum. Wait for things to play out rather than jumping in too early.
Yes, if you jump in too early you enter before everyone else and at a very decent price but you also risk being caught out in fake moves.
Trading is a business all about probabilities and you should do everything that you can to put the probabilities in your favor.
2. Look for a break of trendline on the highest timeframe possible
If you spot a trendline on one timeframe then it is highly possible that a trendline is also formed on a higher timeframe.
It is price action after all and it will reflect on each and every timeframe in one way or another.
Whenever you see a break of the trendline on say the 1 Hour timeframe, then I would suggest that you also look at higher timeframes like the 4 Hour and the Daily timeframe.
If you see a trendline on the higher timeframes too then you should wait for the price to break that trendline too.
By doing so, you will not only get into trades that have higher chances of being a success but you will so avoid falling for bad trades that end up as losers.
Do you use trendlines in trading?
Trendlines are a very common tool in trading and lots of traders around the world use this to make trading decisions, do you too?
What strategies have you developed in order to trade trendlines? Do let me know in the comments section.
Share this blog post with every trader you know and feel free to reach out for any queries through the comments section, I will get back to it at the earliest.