What Is a Trendline in Trading Strategies?

The concept itself is almost childishly straightforward: think of the words “trend” and “line”, and you‘ve basically got it. When learning about markets, many traders seek out effective trendline trading strategies to simplify their analysis. Trying to absorb every data point on a security’s price chart is likely to drown you in complexity. Simply sketching a single, straight stroke that follows the general tendency of the detailed curve, on the other hand, immediately tells you the most important bit of information. Is the market rising, falling, or meandering around between a support and resistance level?

Once this has been determined, a trader can decide to buy or sell in the direction of the trend; they may also decide that the expectation that the trend will continue is not worth betting on – and may even be worth betting against. Trendlines can be applied to almost any kind of liquid asset: stocks, forex pairs, and even cryptocurrency. Their versatility and ease of use make them some of the most widely used price action indicators in technical analysis.

Many of the concepts used in technical analysis are not all that difficult to calculate or, indeed, select from the indicators menu in your online trading portal. However, understanding the fundamental meaning of each, as well as how it is used in practical trading, can be something of a challenge. Trendlines, fortunately, are way more intuitive: all they’re concerned with is whether the market is moving upward (bullish), downward (bearish), or oscillating (sideways). By keeping this vital fact in the forefront of their minds, traders can make better-informed decisions about when and whether to enter or exit a position. Trendlines analysis can also serve as confirmation of the existence of critical, though ever-changing, support or resistance levels.

This is the foundation of every trendline trading strategy.

Basic Principles of Drawing Trendlines for Trading Strategies

At their simplest, a trendline can be sketched by connecting two or more price points on a chart. Now, if you actually try this with points that are close together in time, or in a volatile market, you end up with a line that tells you…not very much: depending on which points you’ve picked, it can point nearly anywhere. Accordingly, one more rational approach relies on “curve fitting”. 

The basic concept behind trendline trading strategies is that, instead of passing right through selected points, the trendline gets reasonably close to as many as possible. The more points that are included and the shorter the average vertical distance separating the line from these points, the more significant the trendline can be considered as a technical indicator. 

As it turns out, curve-fitted trendlines are good for evaluating long-term price tendencies, but don’t really help day traders all that much. However, trendlines can also be drawn between two or more major “swing points”: either peaks or troughs. This, in fact, is the more common approach and the one we will be discussing in relation to short-term trading.

Here are some key principles to remember when drawing trendlines:

• Respect of the line: A valid trendline should be respected by the price action – if drawn between two troughs, but is crossed by multiple intervening troughs, it can safely be ignored.
• The steepness: An overly steep trendline is less reliable – it may be based on market momentum that’s temporary and not sustainable.
• Breaks: If a trendline has been drawn but ongoing price action pushes through it, you may be looking at a potential trend stalling out or reversing itself.

Identifying Trade Signals with Trendline Strategies

Trendline analysis, while reliable enough for most purposes, is somewhat subjective. Two experienced traders may well look at the same line on the same price chart and come to completely different conclusions.

Still, there are some commonly seen, trustworthy trade signals you can pick up on by learning to see price action in relation to the trendline. Some common scenarios are:

• Trendline bounce: When the price comes close to the trendline before veering away from it, it may be the right moment to enter a trade in the direction of the trend.
• Trendline break: A break through the trendline can indicate that the market’s former momentum has been exhausted and a trend reversal is now possible.
• Trendline re-test: After breaking through a trendline, the price may briefly revisit the line before moving in the direction of the new trend.

How Does a Trendline Trading Strategy Work?

The classic way to draw trendlines is to connect, as nearly as possible, a series of swing highs (peaks) or swing lows (troughs). Another thing to remember is that, when tracing a possible uptrend, lines are drawn through the swing lows – short-lived peaks aren’t as informative. By the same reasoning, downtrend lines are drawn with respect to swing highs. As we can see in the diagrams below, such a trendline effectively acts as support for an uptrend or as a resistance level for a downtrend. In fact, these kinds of trendlines are often referred to as “dynamic support” (or resistance) because they take the price trend into account.

When Is a Trendline Valid for Your Trading Strategy?

A trendline is probably worth looking at when it has at least three touch points: times when the price of a security touches the trendline without breaking through it. Of course, the more of these touch points a trendline borders on, the stronger and more significant it is considered to be. 

Because trend lines are somewhat open to interpretation, there is a risk that you’ll squint at one until you believe you’re seeing whatever it was you wanted to see. It’s therefore helpful to have some kind of “sanity check” you can consult before committing any money to a trade. If you see the price action approaching a trendline (but not crossing, except perhaps for Japanese candles’ wicks instead of their bodies) several times, it’s probably the real deal. You may then cautiously assume that it will act as a line of resistance or support for the price of a security; this information can then be translated into potential buy or sell opportunities.

Types of Trendline Trading Strategies: Uptrend, Downtrend, Sideways

Each of these forms the basis of a different trendline trading strategy.
As we’ve touched on, trendlines reflect the three basic types of market conditions. Each requires a different trading strategy and, perhaps, decision-making process:

• Uptrend: The price of a security is moving upward, generally but usually not constantly. The trendline, in this case, is drawn below the price action and acts as a line of support.
• Downtrend: The price of what you’re looking at is heading downward. The trendline is drawn above the price action and can be thought of as a moving resistance level.
• Sideways trend: The price fluctuates, but neither an uptrend nor downtrend can be established. Trendlines are somewhat trickier to apply, as they can act as either resistance or support at different times.

How to Draw a Trendline for Your Trading Strategy

As we’re concerned with how price action developed from the past to the present, a trendline is constructed from the left side of the chart to the right. Anyone can draw a whimsical line that represents exactly nothing, so the rule of thumb is to connect at least three swings (local maxima or minima) in the price to be valid.

To draw an uptrend line, you start with a significant swing low on the chart and connect it to a higher swing low to the right, hitting another swing low in between. The process for a downtrend line is just the inverse, i.e. linking swing highs.

Trendline Trading Strategies and Chart Patterns

Trendlines are essential tools for identifying chart patterns: graphical representations of market movements, which makes these far easier to spot than by looking at sequences of raw numbers. Common chart patterns include wedges, head and shoulders, double tops and bottoms, and triangles. The significance of these patterns is that they can indicate a continuation or reversal of a trend. Trendlines, as visual indicators, can be drawn on the same charts as these to help traders to spot such patterns and trade accordingly.

Trendline Breakout Trading Strategies

This is the most basic question, isn’t it? The strength of trendlines is that they give you a simple, usually reliable way to determine the direction of the price trend. Traders can then do further analysis to decide whether the trend will continue or perhaps reverse in the next few chart periods. With both strategies, the interpretation of the trendline amounts to the same thing:

• While the price is above the uptrend line, the trend is up and bullish plays are called for.
• While the price is below a downtrend line, the current downtrend indicates a bearish strategy.

Besides aiding your understanding of what the market is up to, trendlines enable two general types of trading strategy:

Trend-Following Trendline Strategy

Trend followers assume that the market’s momentum will continue; they therefore buy when the price is rising and sell short when the price is falling. They therefore often use uptrend and downtrend lines to determine whether the overall price trend is higher or lower.

Countertrend Trendline Strategy

Trends never last forever, so it can also make sense to sell when the price is rising and buy when the price is falling. This makes sense in terms of a basic principle of investing, namely to “buy low and sell high”. For short-term traders, the reason to take countertrend positions is the expectation of a reversion to the mean: after trending in one direction, the price will eventually return to its average price or that supported by fundamentals.

Advantages and disadvantages of trendline trading strategies

Arguments surrounding the validity of trendline trading strategies are numerous and varied. Without getting into each of these, we can give you a basic summary:

Advantages: Trendlines can help traders identify not only the overall trend of a market but also potential entry and exit points, and price targets. They are simple to use and understand, and lend themselves well to being combined with other technical analysis tools in order to enhance trading decisions.

Disadvantages: Trendlines are subjective. Different traders might draw different trendlines for the same chart, or interpret the same one differently. The rules of thumb applied are also not always accurate. Sometimes, a price will break a trendline, indicating a reversal, only to continue the original trend more strongly than before.

Special tips for trendline trading strategies

Even while acknowledging the above drawback, we subscribe to the idea that many of the problems traders experience while using trendlines result from simply misusing them. Before making any trade, consider the following:

Is there a trend?

The ultimate newbie mistake with trendlines, and something that you want to avoid, is relying on a trendline when there is no real trend. This is often due to using an inappropriate timescale.

Looking at this chart below – the market is just going sideways. It’s oscillating, so there are brief movements up and down, but it’s no surprise that these imaginary trendlines don’t work.

Source: Action Forex

Trendline Angles in Trading Strategies

Some trading platforms have a built-in trendline tool, which amongst other things shows you the angle of the line. In MT4 (Metatrader 4), this is known as “Trendline by Angle”. The perfect trendline is about 45 degrees. (Note that this also depends on using the correct timescale: compressing the chart above will make the lines seem much steeper.) Anything over this means the price is rising too quickly and is liable to easily break through the trendline, even if the trend continues later. Less than 45 degrees means the trend is weaker and the market is close to trading sideways.

Number of Touches in a Trendline Strategy

The more swing points that a trendline goes through, the stronger the trendline is considered. It becomes more recognisable to more traders, whose trend-following strategies themselves strengthen the momentum. However, experience shows that the chance of the trendline breaking increases significantly after five touches.

Zoom Out for Better Trendline Strategies

Remember to zoom out your trading platform’s chart display, at least until you see the start of the trend you are trying to represent with the trendline. For example, if drawing an uptrend, try to find the low of the previous downtrend and start your trendline there, or perhaps on the next swing low.

Trendline Zones in Trading Strategies

Trendlines, for all their predictive power, can also lead you astray. It only rarely happens that the price will touch a trendline perfectly before reinforcing the trend. For this reason, each line isn’t hard and fast but rather indicates a range rather than a precise, moving price point. This has major implications for your chosen entry price and stop loss.

Trendline breakouts and breakdowns

Two other concepts you need to be aware of are trendline breakouts and breakdowns. The first is seen when the price of a security breaks through a downward trendline, i.e. going up further than the trendline seems to predict. This may mean that a bearish cycle is at an end and the trend is about to turn positive.

A trendline breakdown occurs when the price of a security falls below an upwards, support trendline, potentially indicating a shift from an uptrend to a downtrend.

Forex Trendline Trading Strategies

While trendline trading strategies are a popular way to predict movements in all security prices, it finds particular application in the world of forex and even cryptocurrency trading. Especially in the latter case, technical analysis is often more useful than fundamental analysis.

Though individual traders can rightly claim that forex markets are driven by changes in interest rates, it’s also true that interest rates set by central banks rarely change, while the factors that cause them to do so are also relatively stable. The market therefore moves, in the short term, depending on instantaneous supply and demand as well as traders’ expectations of coming events. Technically inclined forex and crypto traders therefore argue that the only way to get a read on market sentiment is through watching the price action, including by using tools like trendlines.

Stock Market Trendline Trading Strategies

That’s not to say that trendline analysis is at all eschewed by stock market traders, whatever timescale they may invest on. Trendlines are an excellent way to identify potential resistance and support levels, predict future price movements, and make informed trading decisions generally.

Commodity trading and trendline analysis

Commodity prices are affected by more variables than can easily be tracked on a spreadsheet. Software-powered analytical tools that connect to a variety of information sources are therefore particularly useful, but trendlines’ simplicity and widespread use give them an advantage all of their own. Whether we’re talking about gold, oil, or soybeans, a trader can use them to get a sense of how other traders anticipate price movements, then look for profitable opportunities in either the same direction or watch for signs of a countertrend. 

Commodity Trendline Trading Strategies

When all is said and done, a trendline is just another source of information – and they’re not exactly infallible, either. In other words, allowing a trendline to wholly dictate your trading strategy and decisions is a little rash. At times, though, the way the market moves towards, away from, or through a trendline can indeed suggest that certain actions should be taken. Let’s look at two common scenarios, as well as a third that is less well known but often effective.

Trendline bounce

This amounts to a trend-following strategy; specifically, when you assume that the trend’s highs or lows are being resisted (or supported) by the trendline. You may either go long at a price close to an uptrend line or sell short in the region of a downtrend line.

Strategy steps:

1. Establish the general market trend: up, down or sideways
2. Draw a trendline connecting three or more swing points
3. Extend the trendline into the future
4. Wait for the price to again touch the trendline 
5. Set a limit order to execute at or near the trendline (keep adjusting this as the price moves)
6. Enter a trade in the direction of the trend when the price has touched the trendline
7. Place a stop-loss order under the previous swing low in an uptrend, or above the previous swing high in a downtrend
8. Set a take profit order of at least 2:1 the size of the stop loss

Chart example:

Trendline breakout

Trendline breakouts (or, equally, breakdowns) tend to signal a change in the market winds and can therefore be used as a signal to place a countertrend order, but this is not the limit of their usefulness. In fact, a security’s price seemingly defying a trendline break can become part of a trend-following strategy. This relies on good timing and the understanding that short-term trendlines can be outweighed by the bigger trend, resulting in trendline breakouts or breakdowns.

Strategy Steps:

1. Establish the long-term trend – the proper timescale will depend on volatility
2. Wait for the price to correct. i.e. go against the long-term trend
3. Draw a trendline that applies specifically to this short-term correction, still containing three or more swing points
4. Wait for the price to break out or down past this shorter trendline
5. Buy when you see a break of a downtrend line or sell at the break of an uptrend line
6. Set a stop order past the trendline to take profit on the breakout
7. Set your stop loss on the other side of the trendline
8. Set a take profit order at least 2:1 the size of the stop loss

Chart example:

Source: Forex Strategy Resources

Trendlines with confluence

Trendlines are much more accurate than, say, astrology. However, no technical indicator or trading system is perfect. It is therefore highly recommended to incorporate more than one analysis technique when evaluating any trade. A missed opportunity will rarely sink your whole portfolio, though a hastily grasped red herring can cost you a great deal. It is better to wait for chances that are confirmed by more than one method.

Trendlines with Fibonacci retracement

In this chart, a conclusion we might have reached using trendline analysis alone is corroborated by the existence of a 61.8% Fibonacci retracement level:

Trendlines with moving averages

Here, a rising trendline matches the widely-watched 200-day moving average, giving significant confidence in the trend:

Trendlines with Japanese candlestick patterns

Below, we can see how trendline bounces are supported by bullish engulfing candle patterns:

In conclusion

When all is said and done, trendline analysis is as much an art as a science. Before betting the farm on any conclusion reached by it, you may want to switch to a demo trading account and see how often your predictions come true, or test your strategy on historical price data for securities you’re not overly familiar with before committing real capital to any trendline trading strategy.

It’s also worthwhile looking up a few case studies of how trendline trading was applied in real-world scenarios. This allows you to look over the shoulder of more experienced traders, seeing what data they were looking at, what conclusions they reached, what they decided to do, and how it all turned out. Something you will notice, too, is that trendline trading strategies do not allow you to forget about basics such as proper position sizing, risk management, and keeping your overall investment goals in mind.