Finding the True Trend Line

October 27, 2013 in Forex Articles

Many traders fail at one of the most simple things to do when starting to chart a financial product (currency pair, equity, indices, etc). The old saying that the most difficult situations are coming out of the most simple setups seems to be true in this case as well.

Drawing a trend line is something any trader knows (or should know) as a trend line is supposed to be a line that connects at least two different points, and from that moment one it should hold true for the rest of the time the trend keeps going. However, as simple the definition may be, the reality is not as straightforward, as sometimes price is just playing tricks and breaks such a trend line, only for it to resume the initial trend a couple of candles later. So what should a trader do in order to avoid false breaks and, more important, how to treat such breaks? In order to answer to such a dilemma there are some things to take into

First, one should look for a beginning of a trend. Either this is being calculated based on Elliott Waves Theory, after a specific five waves structure is coming to an end (or a three waves structure as a matter of fact), or based on a specific economic release (fundamental analysis), the things to take into consideration from a technical analysis point of view are the same: try to find two points price reacts the most and draw a trend line from the beginning of the move through the second point and look for that trend line to hold true for the rest of the move.

Second, if this trend line is being broken (like the image below shows), than one should take into consideration the previous highs and the previous lows the move made. The most logical thing to do after the trend line is broken is to look for the current highs (if the trend is to the upside) or the current lows(if the trend is to the downside) and wait for the moment they are broken. By the time that is happening, this is a confirmation the trend is still up and the break of the trend line was a fake one.

The opposite is very much true as well. If, based on your analysis (regardless of it) you are looking for price to reverse, then the first thing you should look for is to try to identify a reversal pattern: head and shoulders/inversed head and shoulders, double/triple tops/bottoms, rising/falling wedges, or trend lines to be broken. On the last case, one should look for two things: first, the trend line to be broken, and second, wait for the next swing and see if the highs/lows are being taken. If yes, then this is a confirmation a new trend begins or at least a correction for the previous move is bound to take place. The example below describes exactly the things mentioned above and, as you can see, waiting for the next swing is the most logical thing to do.

All in all, the reason why the majority of traders is failing when dealing with trend lines is caused by the fact that the very definition of the concept is not respected. After all, we are talking here about a trend line, which in free translation means the line of a trend. And if the line of a trend is not broken, then why looking for price to turn when we have no visual confirmation that  the trend is done in the first place?

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