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How to Draw Trend Lines on Stock Charts


It is important to learn how to draw trend lines on stock charts since they form the basis of many popular trading strategies.

There are many methods of drawing these lines. Entire books have been written on the subject. This suggests that trend line drawing is something of an art form. But while this is true to a certain extent, the best methods remain more objective than subjective.

One of the better methods is discussed below. This method allows you to consistently draw trend lines without needing to use a complex algorithm.
In other words, it is fairly simple to draw on any stock chart once you understand what is involved.

This method is widely attributed to Victor 'Trader Vic' Sperandeo. Sperandeo achieved fame in the investing world when he accurately forecasted the stock market crash of 1987 during his September 21 interview with Barron's, a weekly financial publication. He backed up his forecast on October 16 - one trading session prior to Black Monday - when he shorted the Dow and subsequently made 300% during that ominous day when the DJIA fell by 22.6%, which is the largest daily percentage loss in the index's history.

Sperandeo describes his method in Chapter 7 of his 1991 book Methods of a Wall Street Master. There he defines a trend as the prevailing direction of a stock's price within a given period of time. Prices are considered to be trending upward when they rise consistently over time, with only temporary bouts of declining prices which do not make lower lows than the previous price declines. Likewise, in a downward trend prices decline over time, with only temporary price rallies which never rise higher than previous price rallies.

Consider the following stock chart:


annotated Corning (GLW) stock chart without trend line
  GLW stock chart without trend line

Intuitively, you can see that Corning (GLW) has been in a downward trend from February to September 2015. Using more precise language, you would say that GLW is downward trending over this period of time because it makes a series of lower lows, while being interrupted by lower highs during the occasional rally.

But how exactly would you draw a trend line to capture this downward trend?

The method for drawing downward trend lines: Draw a straight line from the highest high point to the lowest minor high point just prior to the lowest low point, making sure the line does not intersect any prices between the two points. The line should then be extended down past the lowest high point, and may intersect prices as it does.

For GLW, the proper trend line would look like this:


corning (GLW) stock chart with trend line
    GLW stock chart with correctly drawn trend line

This trend line is the only line that can be drawn that best satisfies the above criteria. Note that it cannot strictly be drawn from the highest high in this case, because the resulting trend line would intersect prices:



corning (GLW) stock chart with incorrect trend line
  GLW stock chart with incorrectly drawn trend line

Moreover, trying to draw the trend line from a lower minor high point closer to the lowest low point would also be improper. Again, the resulting line would intersect prices:



corning (GLW) stock chart with another incorrect trend line
  GLW stock chart with another incorrectly drawn trend line

Also note how the properly drawn trend line touches prices in 3 places in the GLW stock chart. This is not unusual. While only 2 points are needed to draw a straight line, in actual practice you often see prices touching or 'retesting' the trend line 3, 4, even 5 times or more. This is a welcomed phenomenon in technical analysis. It confirms that the line has been drawn correctly. It also indicates that a stock is trending strongly. All else equal, the more times a trend line has been tested, the more confident you can be that the stock is trending in a particular direction.

To draw an upward trend line, you simply reverse the procedure.

The method for drawing upward trend lines: Draw a straight line from the lowest low point to the highest minor low point just prior to the highest high point, making sure the line does not intersect any prices between the two points. The line should then be extended up past the highest low point, and may intersect prices as it does.

Here is an example:


goldman sachs (GS) stock chart with trend line
  GS stock chart with correctly drawn trend line

Goldman Sachs (GS) is clearly in an upward trend. Between February and the end of June 2015, it made a series of higher highs interrupted by higher lows on the occasional sell-off. The trend line is properly drawn from the lowest low up to the highest minor low preceding the highest high. Extending past the highest low, late-June prices are poised to retest the trend line for the 5 or 6th time, or else to break it altogether and begin a new trend downward.

A final caution. Do not think that once a trend line has been drawn, it is set in stone. Since prices can change drastically from day to day, they may very well upset your neatly drawn trend line. There are actually plenty of scenarios that will cause you to re-consider the viability of your trend line. So be prepared to redraw it.



Now that you know how to draw trend lines, put it to good use!

Begin building a complete swing trading system here.


 



 
 

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Last modified: September 14, 2016