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Trend line

Trend line is drawn by connecting local peeks and throughs on chart. They roughly show us what we can expect in the future. Depending on their directions trend lines could be: upward trend lines and downward trend lines. The upward trend line is drawn by connecting successive minimums and has upward direction, while the downward trend line is drawn by connecting successive maximums and has downward direction.

Upward trend line
Upward trend line

Before trend line is drawn, type of trend must be first identified. For upward trend, trend line is drawn by connecting two minimums (points 1 and 3 in the picture). Some analysts believe that the correction 2-3 must be at least 50% to accept point 3 as second point of line. In order to use trend line, it must be confirmed (point 5).

When the trend line is created it could be used to generate buying and selling signals: buy when the stock price is near the trend line and sell when it is away from it. The trend line can serve as an early indicator of changes in trend. When the price of securities falls below the trend line (in the case of an up trend), this is a sign that the trend is likely to change.

For charts that display data in a specific compression, for example, the daily chart, the question is whether the trend line should be drawn using closing prices or it should take into account daily changes (high and low). Closing price is the most important price in the day, but the trend line should be drawn taking into account the price range in the whole day.

Upward trend line example
Upward trend line example

The breakthrough of trend line could be caused by daily changes while closing price continues to follow the trend line. In this case, the question is whether the trend line should be changed or daily change should be ignored? Unfortunately there is no right answer to this question. Sometimes it's good to ignore the daily changes, and sometimes not.

For trend line breakthrough, it is enough that closing price breaks trend line. However, most analysts believe that it is not enough and that closing price should break trend line by 3% to confirm breakthrough. This means that if the price touches trend line on the price of 100$, it has to move for another 3$ in the opposite direction of trend to confirm breakthrough.

The second filter for breakthrough, which is also used, is time. The most commonly is used "two-day rule": break of the trend line is confirmed if the closing price is breaking the trend line on two successive days.

The importance of the trend line depends on how many times it has been verified, or how many times the stock price returned to the level of the trend line by making more points of which trend line is constructed (points 1, 3 and 5 on picture 1). The greater number of points gives the trend line greater importance.

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