Welcome to this first monthly blog sponsored by the Trendline Mastery home-study course and membership service, available exclusively from Forexmentor.com. To find out more about Trendline Mastery, please visit our public FAQ page via www.forexmentor.com/trendline.
Our plan is to publish these articles once per month, to provide you the opportunity to learn from experienced traders offering practical and road-tested insights into how to apply trendline-based tools and techniques for the purpose of attaining consistently net profitable Forex trading results. My name is Frank Paul, developer and co-presenter of the Trendline Mastery course, along with my project collaborator Peter Bain, who is one of the founders of Forexmentor.com, and the person from whom I first learned about trend lines more than ten years ago now.
As Traders, We’re Learning New Things All the Time
Now, before we start digging into the subject of trend lines, and how you can use them to identify viable Forex trading opportunities, let’s back up a step and talk a bit about the learning curve that most traders go through to finally attain a sense of confidence in what they’re doing, to the point of being able to risk real money in a live trading account with confidence.
Firstly, regardless how long any of us have been at it, most traders would readily acknowledge that they are learning new things about the market all the time. It’s not impossible that you could luck out by stumbling upon a trading educational resource early in your career – a mentor or a book or a trading “system” – that gives you enough of a trading toolkit to allow you to start cranking out winning Forex trades from the get-go.
Generally speaking, though, most of us tend to have our eyes and ears open to new trading ideas and concepts that could potentially expand our horizons, or let us see things in our charts we might not have been aware of before; or at the very least, augment or optimize trading concepts or systems we do already work with. Most of us will at least experience a sense of curiosity from time to time, when hearing about some new tool or technique that we may not have considered before. And that sense of curiosity is a good thing.
Then again, any competent trading educator will typically coach you to find one thing that works and to stick with it, instead of wandering aimlessly from one trading “system” to another, never hanging in there long enough to actually develop a deeper sense of its strengths and weaknesses and how to apply the methodology in a variety of different market scenarios. So, on the one hand, endlessly indulging one’s self in an insatiable quest for some non-existent “Holy Grail” of trading has its perils. And we have to guard against that danger of burdening ourselves with the “analysis paralysis” caused by looking at an over-abundance of new ideas.
But it’s also important that we don’t become too close-minded to new ideas or concepts we might not have encountered before either; that we don’t become so set in our ways as to think there is absolutely nothing else useful we could possibly learn about reading the market in an intelligent and professional manner.
Maybe the best way to summarize all of this is to say that there is a finite number of topics you really need to master to become a competent practitioner in the Forex market, but there is nobody who can pick and choose which of those topics are best suited for you personally, and how they might come together in the form of a coherent trading approach you can call your own. The fact is, all of us are responsible for our own learning journeys, and it is up to each and every one of us to identify and master all the basics.
That being the case, it’s always critically important that any time you test drive a new trading idea, you do so first via back-testing, then via live trading in a demo account until such time as you can log a minimum of 50 trades with a Win/Loss ratio of 60% or better and a Reward/Risk profile of 2:1 minimum (which means that your winning trades are at least twice the size of your stop-triggered trade attempts). And only thereafter, should you even consider applying these tools and techniques in a live trading account, and even then initially at lower than optimum Position Sizing until you feel truly comfortable with it.
A quick recap here: As traders we’re learning new things all the time, but we always need to be mindful of the trade-off between immersing ourselves in new concepts, and yet not wandering around from one trading idea to the next for all eternity, with the result that we never settle into a consistently applied trading methodology.
All of that said, if you have never looked deeply into trendline analysis before, I would suggest that you absolutely owe it to yourself to do so. You might come to the conclusion that it’s not “your thing”, and if so, that’s OK. But you won’t know either way until you at least put in some time and effort learning about it. Conversely, you just might come to the opposite conclusion – as I have done – that trendline analysis can easily serve as the cornerstone of a viable technical trading approach.
Anyways, it was with that kind of learning-hungry mindset – that burning sense of curiosity mentioned several paragraphs ago – that I first encountered the subject of drawing and working with Forex trend lines more than ten years ago now. And it was Forexmentor lead instructor Peter Bain who introduced me to this topic, a lesson for which I am still grateful to this day, as trendline analysis has remained an integral part of my trading toolkit consistently ever since.
Simply put, through all of the many years of intensive, full-time, focused market study that I’ve put in, through all of the trade-by-trade successes and failures, tinkering and fine-tuning of the elements that seemed to be necessary in cobbling together my own personal trading approach, Top-Down Trendline Analysis has literally become the technical cornerstone of my trading. If you were to take that piece of the puzzle away, I simply wouldn’t have the kind of coherent and reliable approach to reading price action which, today, allows me to approach the market with confidence every time I log in to my trading workstation. Only when you have earned that sense of confidence can you truly call yourself a “trader”.
(I need to take a moment here to acknowledge as fully and emphatically as I can that Technical Analysis methods alone cannot provide you a thorough and professional perspective. To trade smartly, one has to also pay attention to Fundamental Analysis. However, that subject is beyond the scope of this blog, and so we will not specifically reference it any further for the time being. Just suffice to say, for now, that Technical Analysis including the use of trend lines is extremely important and valuable, even if not the whole story on how to approach a trade setup. A fully integrated approach makes reference to both Technical and Fundamental Analysis).
Learning Trendline Analysis Properly Begins With Tom DeMark
If you want to, you can begin learning about trend lines by going straight to the proverbial horse’s mouth and check out Chapter One of Tom DeMark’s book entitled “The New Science of Technical Analysis” (hereafter abbreviated as “TNSoTA”), which was initially published in 1994. Tom was the first trading guru to address the issue of drawing and interpreting trend lines with a methodology that was specifically rules-based, bypassing the often sloppy and intuitive approaches that had previously been used by many traders, analysts and forecasters. And DeMark’s methods certainly informed the teachings of Peter Bain and others here at Forexmentor (including me).
That said, Tom tends to write like a lawyer (which is his practical training, after all), which for many of us translates into a somewhat stiff and occasionally obtuse prose that can be hard to comprehend without repeated readings. Not only that, but TNSoTA devotes only a small portion of its length to trendline analysis, with most of its other chapters focusing on various other topics. Again, Chapter One of TNSoTA is not a bad place to begin, but if you want a more fully developed and practical discussion of tools, techniques and strategies for which trend line analysis can be directly impactful, our Trendline Mastery course might be a useful supplement for you to consider.
So, to make a long story short, I began learning about the art (and science) of drawing trend lines from where my first trading mentor, Peter Bain, also first learned about it: Tom DeMark’s book. But over time, it became apparent to us that there was more – much more – that could be done with trendlines than was specifically referenced in TNSoTA. (Please note that this comment is not in any way intended to represent a critically negative appraisal of DeMark’s work – far from it, in fact. Both Peter Bain and I would be as eager as anybody to express our admiration for the important insights and contributions Tom DeMark has made to this subject. In actively teaching ideas that expand upon Chapter One of TNSoTA, we fully acknowledge the benefit of “standing on the shoulders of a giant”, as the saying goes).
That said, before we can even hint at some of the many practical expansions on the topic of Top-Down Trendline Analysis that have been contributed by Forexmentor over the years, we need to start at the very beginning by explaining what a trend line is, what it means, and how you find and draw these annotations on your charts. To apply this form of analysis across multiple timeframes, you logically need to be able to do it on any one timeframe.
Starting At The Beginning: Drawing A Trend Line
So, how do you do it?
Firstly, you need to understand that there are two types of trend lines that can be drawn on a chart; and you have to know which type is suitable or appropriate before you can begin. The first type, we call Common Sense Trend Lines (hereafter abbreviated to “CS trend lines”), which do not necessarily confirm in all respects to the rules-based approach of Tom DeMark, but can still be valid and useful nonetheless, in our collective opinion. The second, we call Tom DeMark Trend Lines (hereafter abbreviated to “TD trend lines”), which specifically reflect the approach discussed in Chapter One of TNSoTA.
In addition to that delineation of trendline type by drawing methodology, we can also distinguish two further types based on directional bias. A bullish trend line (interchangeably referred to also as a “demand” or “support” trend line) has a positive, upwards slope, capturing rising price action from left to right on your chart. A bullish trend line denotes a progression of generally higher highs and lows over time, and the best way to profit from such moves, of course, is with a buy bias (unless you happen to be looking for a shorter-term counter-trend scalp trade, which is a style we do not address in this article).
Not surprisingly, a bearish trend line (interchangeably referred to also as a “supply” or “resistance” trend line) has a negative, downwards slope, capturing falling price action from left to right on your chart. A bearish trend line denotes a progression of generally lower lows and highs over time, and the best way to profit from such moves, of course, is with a sell bias (again, notwithstanding the possibility of pursuing counter-trend scalp buys for those so inclined).
If we put the above two delineations together, there are a total of four different trend lines that can be conceivably drawn, as summarized in the following table:
Figure 1: Four Basic Trendline Types
|DeMark||TD Demand Trendline||TD Supply Trendline|
|Common Sense||CS Demand Trendline||CS Supply Trendline|
Before you decide between drawing a TD trend line and drawing a CS trend line, you need to be able to glean the directional bias that conveys a trend underway (assuming there is one, and that is not always the case). There is no mechanical rule or guideline for doing so; you simply have to be able capture, with your naked eye, a left-to-right upwards or downwards drift in price action itself.
If you need to break it down into finer detail than that, you can apply the concept of Market Flow: Where price rallied to a Swing Point High, pulled back to a higher low than the last major swing low, then rallied to a fresh high above the last one – in other words, where you can see a progression of at least two higher highs and lows in sequence – then you have bullish Market Flow. In that scenario, drawing the relevant bullish trendline is virtually as easy as connecting the ascending lows in question. Conversely, bearish Market Flow can be said to exist where price puts in a leg down from a Swing Point High (into a Swing Point Low) then rallies to a lower SP High before breaking the most recent low in the downwards direction. As long as that progression continues, a diagonal line connecting the lower highs – i.e. a bearish trendline – is still intact and still conveying the high probability trend bias on that timeframe.
So all of that sounds pretty easy, right? Well, not exactly. It is not always the case that the market is making a uniform progression of fresh highs for an uptrend, or fresh lows for a downtrend. In fact, by some estimates, most Forex pairs are truly “trending” on any given timeframe only about 30% of the time, while the balance of 70% of the time, they are either consolidating (choppy), or rangebound.
In these situations, trendline analysis can become virtually useless (except, possibly, if your intention is to scalp the smaller moves occurring within a range) simply because the thing we’re trying to capture with a trendline – a sustained leg up or down – just isn’t there.
We won’t involve ourselves too much with describing or illustrating these non-trending market environments. Suffice to say that a consolidation market is typically conveyed by short-lived and erratic stabs upwards and downwards without mapping a clear progression of higher highs or lows (very often found as the market has become “exhausted” following a previous extended run of some kind); while a rangebound market has price undulating up and down between parallel support and resistance lines in a so-called channel formation. Whenever you are able to detect one of these scenarios, you’re better off not looking for a trend-trade at all on the pair in question, and devoting your attention instead to other pairs not so encumbered, until such time as price breaks out of the trading range formed by the consolidation or rangebound pattern.
So let’s recap where we are at this point: We can see either an upwards progression from left to right (that is to say, from a major Swing Low at which price reversed from down to up, with a rally extending most or all of the way to the live edge of price action on the extreme right-hand side of the chart); or a downwards progression from left to right (from a major Swing High at which the trend reversed from up to down, taking price to the far right-hand side of the chart). And that progression obviously shows no signs of a consolidation or rangebound scenario emerging in the meantime.
The next step is to determine whether the bullish or bearish bias detected is best reflected by a CS trend line, or a TD trend line. The answer to that question comes down to whether the ascending price action in an uptrend is easily spotted by way of prominent rejection wick lows which can be joined together with an upwards sloping diagonal line; or if the descending price action in a downtrend is easily spotted by way of prominent rejection wick highs which can be joined together with a downwards sloping diagonal line. In other words, are there prominent connection points on candle wicks (rather than bodies) which allow us to draw the trendline? If so, then we go ahead and do exactly that: Connect the rejection wicks with a diagonal line. And – hey presto – there’s your TD trendline.
We don’t have empirical data to back us up on this statement, but in case you’re wondering roughly how often you’re likely to defer to a TD trendline over a CS trendline, we would estimate that a good 80-90% of the time, it will be a TD trendline that’s called for. About 10-20% of the time, you’re more likely to draw a CS trend line. Now, that sharp difference in frequency between the two types might cause you to wonder why you would even bother with CS trendlines at all. The simple answer is that both types are easy to master, and it certainly doesn’t hurt to be familiar with both.
In any event, the scenario in which you are more likely to draw a CS trendline instead of a TD trendline, is when an upwards or downwards progression in price action is not specifically reflected by rejection wicks, but rather by candle bodies themselves. There’s no simple answer here for how you become adept at detecting these linear moves – simply put, it comes through practice and experience. After a while, you just kind of “see” the line as an act of pattern recognition. As is true of so many things in life, if you train your eye to see what you’re looking for, as long as you’re doing it correctly, you will see it.
So – to reiterate – the informal “rule” for when you will want to defer to a CS-style trendline drawing rather than a TD-style line, is when higher highs or lows can be detected, but wicks forming on individual candles within the leg up or down are not pronounced enough to provide clear and obvious connection points for the trendline itself. In such situations, you will connect the trendline to candle body highs (in a downtrend) or to candle body lows (in an uptrend), in place of more clearly formed rejection wicks.
A word on connection points: You may be wondering how many are required to draw a trendline. The simple answer is: A bare minimum of two. And that is true for both CS and TD style trend lines. If you don’t have at least two connection points, the line you are attempting to draw is probably not valid. Conversely, the best trendline you can draw is the one that captures more than two connection points, and as many as possible.
For example, let’s say that after drawing the initial version of the diagonal line, price retraces back to touch it (on a so-called retest, whether finding support on a bullish trend line, or resistance on a bearish trend line), then progresses further in the direction of the prevailing trend. That could happen several more times before price finally breaks the line, and the more such retests (or connection points), the “truer” or stronger the trendline drawing is. In that scenario, the market sees the support or resistance, is reacting to it, and thus the trendline correctly denotes the directional bias in the market.
Now that we have an idea how to draw a trend line, what do we do with it?
What a Properly Drawn Trend Line Can Tell Us
Now that you can hopefully glean the most important aspects about how to draw trend lines (with the diagonal line drawing tool available in just about any commercial grade charting platform), you’re probably wondering what these chart annotations convey.
The first and most obvious thing they tell us is what the high-probability trend bias is (again, assuming there is one, and that is not always the case). The simple interpretive rule that can be applied in this case is that as long as no individual candle or bar achieves a CLOSE on the opposite side of the trendline (specifically, to below a bullish trend line, or to above a bearish trend line), then that line is still intact, and so is the directional bias it conveys.
This factor is so very important to stress: On any individual bar or candle, it is not enough for price to briefly “break” through it on the current open bar, for the very simple reason that false breakouts can and do happen, and if you are impatient and decide not to wait for the CLOSE (instead of a mere high or low) before looking to take action, you could find yourself getting into a trade too early, and possibly getting quickly stopped out thereafter. False breakouts in real-time are a very real and ongoing occupational hazard of working with trend lines, and the best way to avoid them is to insist on a candle close on the other side to confirm a true “break”.
So, as long as price keeps closing on or above a bullish trendline, or keeps closing on or below a bearish trendline, the trend conveyed by the diagonal line is still intact, and we look to trade in that direction. To know that trend lines can provide us a clear directional bias for our trading decisions might sound like no big deal, since there are other chart technicals – most particularly indicators – which many traders believe they can rely on for the same purpose.
But do you want to know something?
There is not one single indicator on earth that can tell you with greater timeliness or accuracy either what the current trend bias is, or where a meaningful top or bottom reversal may be occurring, than a properly drawn trendline (particularly when employed in a multi-timeframe, top-down environment – more on that later).
How can I make that claim?
Well, there are at least two reasons I can think of…
- Most indicators are based on period settings that are completely arbitrary. Period settings, for most indicators, dictate the length of the “look-back” period, the number of bars of OHLC data which inputs into the indicator’s formula. So, a 20-period Exponential Moving Average is intended to capture the trend over the last 20 bars. And a 12,26,9 MACD captures the difference between a 12-period “fast” EMA and a 26-period “slow” EMA, that differential in turn smoothed by way of a 9-period EMA. The problem is, price action is not dictated by period settings in an indicator; it is dictated by the relative strength of supply versus demand in the market. While a 20-period setting of an EMA may occasionally provide a reading that is true and accurate, some other time it might not, and if one had plotted a 50-period EMA instead, that alternative version would have been more useful in that sole instance. But you can’t constantly change indicator settings to suit price action, because there is no logical basis for doing so. And thus, sometimes one indicator setting will be accurate and useful, and other times it will not. By contrast, trend lines are drawn directly on price action itself and thus are not affected by this so-called periodicity problem.
- Most indicators to do two things at once, which can produce muddy readings. With any of the popular, so-called “oscillator” style indicators (for example, Stochastics), the reading is inevitably affected by two things at once: A prevailing directional bias, and shorter-term deviations from it, which can result in a conflict. Let’s say that momentum has been generally bullish over the past 14 bars. In that case, Stochastics should be sloping upwards and showing clear “Gap and Angle” to its signal line. But, in the meantime, if price deviates briefly from that trend over a smaller timeframe, the reading could easily become harder to interpret, maybe even resulting in a false crossover signal. The nice thing about trend lines, by contrast, is that individual bar-by-bar deviations which do not result in a close on the other side of the line do not change the directional bias conveyed by the trendline. Simply put, its linear slope will remain intact even through the “noise” that so often generates muddy or confusing signals on an indicator panel, and will thus be easier to interpret and work with.
Caption: An Example of a False Bullish Crossover on Stochastics Which Is Contradicted By TL Analysis
So, as you can see, trendline analysis conveys the benefit of providing trend readings that are often more accurate, and conversely less prone to “noise”, than what is possible most of the time with standard technical indicators available on most charting platforms.
To recap: The two primary readings a trend line can provide us are:
- Conveying the high-probability trend bias – as long as price does not close on the other side (e.g. to below a support trendline); and:
- Conversely, signaling the onset of either a corrective reversal or an outright trend reversal when price does, finally, achieve a close on the other side.
But as important as those functions are, they only scratch the surface of what you can do with trend lines when employed in top-down fashion. Other things they can do for us traders include: Providing effective entry points into a trend trade (when price breaks on the other side of a corrective trendline that runs contrary to the trend bias conveyed on the higher timeframes), and providing often amazingly accurate price projections which help us “let profits run” to a logical exit target on the trade. Those subjects require a bit more elaboration that we have time and space available within this inaugural blog article, but we will definitely turn our attention to them in future articles.
Trendline Analysis Is Best Applied In Top-Down Fashion
The next lesson you need to learn is that you can draw trend lines this way and that on any one timeframe in isolation, but, particularly as you drill down to lower intraday timeframes (i.e. 60m, 15m and 5m charts), about half of those line drawings at any given time will be invalid and unreliable.
Why is that?
Simply put, a trendline can denote two entirely different price tendencies: 1) A corrective move; or 2) A trending move (sometimes referred to as an “Impulse Wave”). Corrective moves on lower timeframes can be very short lived and difficult – often impossible – to trade in their own right. Generally speaking, we want to find a strong trend bias on one or more higher timeframes, and then use that bias to help us interpret the type of trendline we might see on a lower timeframe drawn on differing parameters. For example, a short-lived, bearish trendline on the 60m chart will usually be deemed corrective (i.e. counter-trend) if running in opposition to strong bullish trend lines found concurrently (again, drawn on different parameters) on the Daily and 4hr charts. Furthermore, the upside break of the corrective resistance trendline on the lower timeframe running against dominant support trend lines higher up, can provide us a good entry signal into the trend trade.
In the two-part chart example below, the top panel captures a dominant resistance trendline in force on the 4hr chart. Against that trend, shorter term rallies which do not break the trendline on a close should be deemed “corrective”. In the bottom panel, we see a lower timeframe – the 60m chart (both green shaded rectangles capture the same timeframe on both charts) – which, for a time, draws in a support trendline, which is counter-trend to the 4hr. When price breaks the lower level corrective trendline into the direction of the higher level dominant trendline, a strong breakout move ensues. That type of pattern alone can be trading gold for you, if you take the time to understand how to detect it, and how to act on it.
Now, all of that probably sounds fine as a general description. But general descriptions are not the same thing as a trading system methodology which allows you to be more precise and routine in your delineation of an ideal trade setup. So, even though there are exceptions to every rule in trading, and thus you might be able to find good trades that don’t specifically conform to the rule we’re going to lay out for you, it’s always the case that we have to start somewhere, and just go with it.
So, to avoid the problems that often ensue when trying to work with trendline annotations on just a single timeframe, we can specify the top-down conditions that provide for the strongest and most actionable trend readings, all the way down to a trigger event on one of the lower timeframes that would enable you to get into a trade.
In a very broadly defined way, these top-down conditions look for a trend reading that is anchored on the Daily chart, enabled by at least a limited degree of compatibility on the next two higher timeframes (Monthly and Weekly), as well as the next lowest (4hr), resulting in up to four consecutive timeframes all pulling in the same direction based on what the current state of trendline analysis on each of those timeframes is. Next, we will drill down to the so-called intraday charts and look for a trendline which aligns in opposite (i.e. counter-trend, or corrective) fashion to the higher-level reading: A bearish, corrective trendline on any (or all) of the 60m, 15m and 5m charts, for example, against bullish trendline analysis intact on all of the 4hr and higher timeframes. When price breaks (again, with a CLOSE, not merely a high or low in real-time) the corrective trendline in question on the intraday timeframe, we have an indication of a continuation move afoot, which is very often an optimal point of entry into a breakout trend-trade.
The following table summarizes the conditions we tend to look for in bullish Top-Down Trendline Analysis, to enable an effective entry point into the prevailing uptrend, culminating in the break of a low-level corrective trendline as the entry trigger (for a bearish example, simply invert all the elements):
Figure 2 – Delineation of a High-Probability, Bullish Top-Down Trend Trade Setup
|Timeframes||Types of Trendline Analysis|
|UPPER – Trending on all four (incl. Monthly, Weekly, Daily)||– Rising Support Trendline
– Bullish Trend Channel
– Recent upside break of a prior Falling Resistance Trendline
|LOWER/INTRADAY – Corrective on at least one (incl. 60m, 15m 5m)||– Falling Resistance Trendline
– Bearish Trend Channel
The best way to illustrate the above scenario would be with chart captures from all relevant timeframes into a successful trendline-based trade example. That is outside the scope of this article, but will serve well as the topic for our next installment, which will be posted in February. We’re looking forward to seeing you back here at that time.
In conclusion, we’d like to thank you for joining us here today. We sincerely hope that this blog article has provided you some useful insights into the topic of trendline analysis for Forex trading. If we can ever answer any questions you might have, please see the Member’s Forum available at the Trendline Mastery membership site (www.forexmentor.com/trendline), or send us an email message (with the subject header “Question on TL Analysis”) to: firstname.lastname@example.org. Please also be sure to follow our Twitter feed (@fxmtrendline).
 A Swing Point High is a five (occasionally six) bar pattern with a middle high, ideally presented by a rejection wick, both preceded and followed by lower highs on the two bars before and the two bars after the central high. If two consecutive candles share the same high – again, preceded and followed by two lower highs on both sides – you have a Double Swing Point High. A Swing Point Low simply inverts this pattern with a central rejection wick low preceded and followed by two higher lows on both sides.
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