Recently we received a question from one of our members asking if it is ok to use trend lines for her trading entries after she determined sentiment and direction from the news.
The short answer is yes, but of course we will dive a bit further into the subject and explain how trend lines can be useful, as well as give you some tips on how to apply them successfully when trading.
Let’s start by explaining exactly what trend lines are. Currency prices are continuously moving up and down, even within a trend, which can make determining the best place to take action a challenging endeavor for a new trader. This is where trend lines come in because they can help us to gauge when the best time to action is. Trend lines are actually quite versatile because they can be used for entries, exits, and even trade management (reducing risk and locking in profits). It also helps that they are one of the most widely used technical analysis tools.
First we will show you how to draw a trend line in an uptrend. An uptrend is defined as price making higher highs and higher lows. To draw a trend line you want to draw a line connecting the higher lows and extend it out into the future as shown in the example below. You can see by doing this that trend lines also offer a time element that you don’t get with horizontal support and resistance.
Next let’s look at drawing a trend line in a downtrend. A downtrend is defined as price making lower lows and lower highs. To draw a trend line you want to draw a line connecting the lower highs and then projecting that out into the future as shown in the example below.
It is also important to adjust the trend lines with new swing points, and you will often find that you will need to allow for some spikes through the trend line where price tested and failed to break the trend. This is why many traders will use the candle price closes instead of the exact swing points as the trend progresses and we have more price information.
Now that we know what trend lines are and how to draw them, let’s take a look at how we can use them to help determine the best places to take action based on our overall fundamental view.
The goal of every trader is to buy low and sell high within a currency price trend. Trend lines give us a way to identify the high and low ranges of the trend. As an example, if we are looking to buy a currency based on our fundamental view and it is pulling back to the up trending line, this gives us an area to buy the currency at a low price in the current trend. The exact same is true in a downtrend. If we are looking to sell a currency based on our fundamental view and it is pulling back to the down trending line, we now have an area to sell the currency at a high price in the current trend.
Another way to use trend lines for trade entries is if the current trend is going against your overall fundamental direction. In this case you would want to wait for the current trend line to break down giving you a good indication that the currency is going to move back in the direction of the bigger picture fundamentals.
As with any technical level, trend lines work best in confluence with other levels of support and resistance such as horizontal price support and resistance, Fibonacci levels, and pivot points.
Trend lines can also be very useful when placing your stop loss to manage your risk. A good stop placement can be below the current trend line in case the trend does indeed change. With that said, we would not suggest putting your stop loss too close to the trend line as these levels can be tested and see quite a few “false breaks” where price spikes through and quickly reverses. This often happens when price dips through a trend line taking out stops that are placed too close causing a short term run in that direction.
Finally, trend lines are also very effective for trade management. By trailing your stop behind the trend line you can protect your position by reducing risk, removing risk, and locking in profits as price continues with the trend. This will protect your position, and your capital, if the trend changes.