How to Draw Trend Lines
It's important to know how to draw trend lines on stock charts. Why? Because the trend line forms the basis of many popular trading strategies. So if you want them to work as they were intended, and to bring you in the greatest profits, learning how to draw these simple straight lines is critical.
There are many methods of drawing trend lines. Entire books have been written on the subject. This suggests that trend line drawing is something of an art. But while this is true to a certain extent, the best methods remain more objective than subjective. That means there is a science to it that you can learn with a little study.
One of the better, and simpler 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 easy to draw on any stock chart once you understand a few basic rules.
This method is widely attributed to Victor Sperandeo. Trader Vic, as he is widely known, 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:
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:
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:
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:
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:
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.