Tools: Analysis Using Trend Lines

The six tips illustrated are effective techniques for finding winning trades and maximizing profits.  Even though my illustrations make it look easy, the process of analyzing charts and trading is still hard work.  Also, I have the benefit of hindsight in selecting a good example to use to illustrate these tips.

The Power of Trend Lines
I am frequently asked which is the best study or tool to use to trade the markets.  I think the best analytical tool is drawing a straight line on a chart beneath the lows of bars to show a rising trend, and above the highs of bars to show a falling trend.  A tool this simple does not require a computer.  Yet, because traders have computers, they overlook the power of a trend line, and number crunch massive quantities of data through complex formulas searching for a secret methodology no one has discovered.  Forget it.  I have been there and done that.  I keep coming back to the simplicity of manually drawing trend lines on a chart.  When the chart trend reverses and breaks through the trend line, a new position is taken.  This is the primary tool I use, and everything else you learn is just an enhancement to the power of the trend line.

Ensign Windows has a very powerful and unique tool called Auto Trends, which is illustrated on the chart above.   The trend lines are calculated and drawn automatically by the software, in real-time.   The tool has proven to be very helpful and greatly appreciated by many day traders.   The Auto Trends tool has several options that increase its value.  These options can be seen on the property window for the tool.

An Alarmed trend line will display an alert message box in green when price action breaks upward through a descending trend line, and display an alert message box in red when prices break below the ascending trend line.

Average Trend uses the principle of Parallelism in trends, and suggests the next trend based on the average slopes of prior trend lines.    This feature is illustrated in the next chart.

The red trend lines are the average trend lines and show the typical slope seen in earlier trends.

Channel Lines and 50% Lines (mid-channel) can be added by checking the boxes for those options.

The Gann 1x1 option will automatically place the 1x1 line on the chart from the swing points.  This is similar to placing a Gann fan on the chart to show the 1x1 line.   The slope for the Gann 1x1 line is determined by the proprietary technique Ensign Windows uses to square price and time.

The last two options for the Auto Trends tool can be used to show Support and Resistance and Break Out trend lines, as illustrated in this chart.

The Power of Parallel Lines
The first analysis principle is that prices move in trends, but the trends do not last forever.  Eventually price movement changes direction and breaks through the trend line.  The second principle I use is observing that up trend lines are frequently parallel to each other.  This means there is a repeatable chart characteristic in the rate at which price movement advances.  Likewise, down trend lines are frequently parallel to each other.  I use this principle of parallel lines to give me an idea of what would be a typical up trend or typical down trend when price movement changes direction, and a new trend starts.

The Power of Pennants
Pennant formations indicate the balancing of opposing market forces.  The pennant is a narrowing triangle where prices are making subsequent lower-highs and higher-lows.  Prices usually break out of a pennant pattern rapidly with the frequent presence of a gap, increased bar range and increased volume.  Join the move in the direction of the break-out. Odds favor a breakout to the upside from an ascending pennant, and to the downside from a descending pennant.  A smaller variation to a pennant is a flag where price movement pauses and moves sideways after a steep move.  Odds favor a break away from the flag to resume in the same direction.

The Power of Fibonacci Price Levels
Fibonacci price levels are constructed by drawing horizontal lines at the top and bottom of a recent trend.  The band is then sub-divided with additional horizontal lines at significant percentages.  The three retracement sub-division percentages I use the most are 38.2 percent, 50 percent, and 61.8 percent.  These percentages are members of a set of Fibonacci Price levels.  When a trend is being used to forecast the size of a subsequent larger trend, the significant percentage I use is 161.8 percent.

Prices often extend or retrace to these Fibonacci price levels, and then reverse direction.  Confidence is increased that a trend has fulfilled itself when its slope is parallel to other trends, the number of bars in the trend is a Fibonacci count, and the price is near a Fibonacci price level.  Fibonacci Price Levels are easily constructed on an Ensign Windows' chart using the trend top and bottom I select.

Another principle of horizontal lines is that previous resistance becomes future support, and past support becomes future resistance.  Always consider significant support and resistance levels from the past and extend horizontal lines at these levels into the future.  Note in the example that the pennant point consolidated on the horizontal line I labeled as Fibonacci Bottom for the first 5 wave down trend.  Also, this horizontal line was resistance to a couple of the wave tops I labeled with 4 and diamond 4.

The Power of Counting Waves
Underlying forces cause markets to move work in ways that create identifiable patterns, or a series of waves.  Big trends are called impulse waves, and each impulse is followed by a correction wave.  The theory named after Ralph Nelson Elliott, is basically expressed that there will be 5 waves in the main trend, followed by 3 waves in the corrective reaction.

I keep it simple. I look for trends with 5 waves, and corrections with 3 waves.  If I see the pattern, my confidence is increased that the current price movement is due for a reversal.  I also look at longer term daily, weekly and monthly charts to consider the direction of the security in its bigger picture.  Trade with the trend and use corrections as opportunities to join the direction of the main trend.

The Power of Counting Bars
Over and over again, I am amazed at the repetition when I count the number of bars in a trend.  The count frequently is one of the following numbers: 3, 5, 8, 13, 21, 34, or 55.  These numbers are members of a set of numbers called the Fibonacci number sequence.  Take any chart and use a straight edge to mark the trends.  Count the number of bars in each trend and label the trend line with the bar count.  Each chart will have a characteristic that starts to appear.  I have seen charts that with regularity move up and down for either 5 or 8 or 13 bars, and then reverse direction.  This tip can be used to develop patience, and know with greater accuracy on which bar  the trend top or bottom will be put in place.  For example, there are 8 bars in the trend from the point labeled diamond 4 to point diamond 5.

I hope you enjoyed this review of 6 simple yet effective tools to use in analyzing your charts.  Keep it simple, and stay on the right side by trading with the trend.

Article by Howard Arrington