What is a trend line?

In the context of financial markets, a trend line is a diagonal line drawn on a chart. These lines connect specific data points, making it easier for chart readers and traders to observe price movements and identify market trends. Trend lines are considered the most basic tool in technical analysis (TA).

Trend lines are widely used in stock markets, fiat currencies, derivatives and cryptocurrencies. In essence, trendlines work like support and resistance levels but are diagonal, not horizontal. That way, these lines can have a positive or negative slope. In general, the greater the slope of the line, the stronger the trend.

We can divide trend lines into two basic categories: rising (uptrend lines) and falling (downtrend lines). As the name suggests, an uptrend line is drawn from a lower to a higher chart position. This connects two or three low points, as illustrated in the image below.

Conversely, a downtrend line is drawn from higher to lower positions on the chart. It connects two or more high points.

In conclusion, the difference between these two types of lines is the choice of points used to draw them. In an uptrend, the line will be drawn using the lowest point in the chart (i.e., the base of the candlestick that formed the higher low). On the other hand, a downtrend line is drawn using the highs (i.e., the candlestick tops form lower highs).

How to use trend lines

Based on the chart's highs and lows, trend lines show where price appears briefly to oppose the prevailing trend, tests it, and then reverses in its favor. The lines can then be extended to try and predict important future levels. As long as the trend line is not broken, it is considered valid.

While trend lines can be used in any type of data chart, they are usually based on market prices. This means that trend lines can also provide in-depth knowledge of market supply and demand. Naturally, an upward trend line indicates increasing purchasing power (demand is higher than supply). A descending trend line is associated with a consistent decrease in prices, indicating the opposite (supply is higher than demand).

However, trading volume should also be considered in an analysis. For example, if prices are increasing, but volume is decreasing or low, this could give the false impression of increasing demand.

As mentioned, trend lines are used to identify support and resistance levels, which are two basic but very important technical analysis concepts. An ascending trendline indicates a support level below which price is unlikely to fall. Conversely, a descending trendline highlights a resistance level above which the price is unlikely to rise.

In other words, a market trend can be considered invalid when support and resistance levels are broken, whether downwards (for an uptrend line) or upwards (for a downtrend line). In many cases, when key levels fail to hold the trend, the market tends to change course.

But still, technical analysis is something subjective, and each person can show very different methods for drawing trend lines. Thus, it may be necessary to combine some TA techniques, as well as fundamental analysis to reduce risk.

Draw valid trend lines

Although trendlines can technically connect two points on a chart. But most chartists agree that using three points or more will make a trendline valid. In some cases, the first two points can be used to determine a potential trend, and the third point (extended later) can be used to test its validity.

So, when the price touches the trend line three or more times without breaking it, the trend can be considered valid. Testing the trend line several times shows that the trend is not just a coincidence caused by price fluctuations.

Scale settings

In addition to selecting enough points to create a valid trendline, it is important to consider the proper settings when drawing it. Scale settings are one of the most important graphics settings.

In financial charts, scale relates to the way price changes are displayed. The two most popular scales are arithmetic and semi-logarithmic (semi-log). On an arithmetic chart, changes are expressed evenly as prices move up or down on the Y-axis. Semi-log charts express variations in terms of percentages.

For example, a price change from $5 to $10 will cover the same distance on an arithmetic chart as a price change from $120 to $125. However, on a semi-log chart, a 100% gain ($5 to $10) would occupy a much larger portion of the graph, compared to a 4% gain from $120 to $125.

It is important to consider the scale settings when drawing trend lines. Each chart type will produce different highs and lows, which of course will also produce different trendlines.

Closing

While trend lines are a useful tool for technical analysis, they are far from easy. The choice of points used to draw a trend line will influence the extent to which this line accurately represents the actual (real) trend. This makes trend lines somewhat subjective.

For example, some chartists draw trend lines based on the candlestick bodies, ignoring the wicks. While others actually prefer to draw lines according to the high and low of the axis.

So, it is important to use trend lines with other charting tools and indicators. Known examples of other TA indicators are Ichimoku Clouds, Bollinger Bands (BB), MACD, Stochastic RSI, RSI, and moving averages.