Many traders use a trend line as a tool to trade in the market. There are a countless number of strategies on trend lines on the internet and the books. There is a misconception that there are many ways to draw a trend line. Well, that is incorrect. There is only one way to draw a trend line. All the trend lines cannot be correct as the price cannot respect all of them. Most of the traders draw lines without any logic behind it. The moment the price hits the trend line, people hit the buy/sell button. Unfortunately, this is not how it works. There is pure logic behind drawing a trend line. Also, drawing a trend line perfectly does not mean that we can hit the buy/sell button once the price touches the trend line. Several other factors go into it as well. Going forward, we will discuss the same in detail.
Before getting right into the drawing part, some prerequisites should be known. Moreover, the whole idea of drawing a trend line lies in this prerequisite knowledge. The key to drawing a trend line correctly is mastering true Support and Resistance. A straightforward topic, yet misunderstood and neglected by many traders. Well, according to me, understanding true Support and Resistance is sufficient to trade the markets. Trend lines help in giving a clearer picture of the market. Hence, it is an important tool when it comes to trading as it also helps in determining where the price can possibly turn around.
Mastering Support and Resistance
As mentioned above, having a clear understanding of the Support and Resistance concept is very curial from drawing as well as for trading in general. Therefore, let us grasp the idea of Support and Resistance entirely.
Support and resistance can be comprehended in many ways. However, for a Price Action trader, technically, Support and Resistance is a “wall.” And psychologically, it is “memory.” There is nothing beyond this to understand about Support and Resistance if you understand the meaning of the two quoted words.
Consider the below example
Which one of the two represents true support and resistance? If asked to an average trader, they would say both of them are true support and resistance. However, this is not incorrect. The more accurate answer is Figure 1. It represents true support and resistance. Because, the price was coming down so strong, the buyers came and stopped the strong down move and turned the market partially towards the upside, making it a significant level. Also, people remember that price where the market turned around, as the up move was quite strong. Hence, this can be considered as true support. And once the price breaks this support level; it is referred to as true support and resistance. On the other hand, in figure 2, the seller was coming down strong, and the market halted for a while. Then, the price went up quite a little up. Now, will the public ever remember this price? Most probably they will not, as the up move did not catch the eyes of the public. Hence, there is no logic for the price to hold there the next time. Therefore, this cannot be considered as true support and resistance.
Hence, support and resistance is a level where a price holds and turns the market around.
How to draw a legitimate Trend Line?
Now, as the concept of support and resistance is clear, let us go ahead and understand how to draw a trend line. The trend line is a unique phenomenon in the trading industry. People draw trend lines like they are connecting dots with no logic behind it. And, if there is no logic, there is very little probability of the trend line that drawn is correct.
A trend line is basically a Support and Resistance line in a tilted manner. Therefore, the concept behind both trend lines and support are resistance is very similar.
To draw a trend line, we connect the corresponding support and resistance levels. So, identifying the correct S&R levels is essential. An example supporting the statement is given below.
In the above figure, we see that initially, the market is going down, and then it moves sideways for some time and finally blasts to the upside. Let us assume that the price is at the point marked “2.” And, when the price goes up, we start to draw the trend line by connecting point “1” and “2.” We are now anticipating to buy when the price touches the trend line again. And, let us say we hit the buy when the price touched the trend line for the third time and kept the stop loss right below the trend line. But, what happens to our buy? The price goes lower than the trend line and hits our stop loss. This implies that the trend line drawn was incorrect. The right way to read and draw the trend line is as follows.
In the above figure, we see that the price is coming down, retraces about 30% and then goes down again, and this time it comes right back up very sharply. This means that the price did not hold down there. It is just a wick or a tail if looked in a higher timeframe. Hence, we discard the down move that happened. After coming right back up, the price starts to hold at the place where the seller had retraced 30%. Hence, this now becomes our true support and resistance line. Now, to draw the trend line, we wait for a new support and resistance line to form so that we can connect the two support and resistance lines. Once the trend line is drawn, we wait for the price to come back to the trend line so that we can buy from there. Therefore, now there is more probability that the trend line will hold as it is drawn correctly. Also, we can infer from the figure that the price does hold at the trend line and eventually goes up. Therefore, this the right technique to a trend line.