Drawing Trendlines – Are you creating traps for yourself?

We all draw trendlines on charts without thinking too much about it

We take a stock chart and then before you know it, lines end up littering a perfectly good chart.

Lines everwhere…

  • Horizontal
  • Upward sloping
  • Downward sloping

But have you ever stopped to think about the reason behind why we do this?

What is really happening to cause a security to “behave” in the future and react to these lines?

There are some very real traps that I think we need all need to be aware of when drawing trendlines.  I think that most of these traps exist with sloping trendlines and not horizontal trendlines.

First, let’s simply look at horizontal trendlines and then I’ll venture into the minefield that is sloping trendlines.

Horizontal trendlines are based upon a single price.  Transactions that occured at a specific price, or general price area.

For instance, look at this chart:

You can clearly see here that this stock, ANET, has a horizontal support/resistance line right around $240.  That line has been touched multiple times since November of 2017, until last month, in May of 2018.  Buyers and sellers are evenly matched right at that $240 area.

But what is happening to cause this?

That price point came about in November of 2018, when the stock had a very significant rise.   As it approached that $240 mark, the upward movement stopped, stalled, and then was rejected.  Sellers came out of the woodwork here.  They confidently pushed the price down from there.

Soon, the stock rallied back up to $240 with buyers stepping, hovered at that line for about 2 weeks and then rallied upwards, breaking above that $240 mark.

From there, you can see some fairly sharp swings above the line with some very sharp moves.  Each time from that point forward, $240 seems to hold, where sellers dry up and/or become insistent, and buyers perceive value and start aggressively buying at that specific area.

This line is real.  It’s based on price. 

Trading is occurring back and forth at that specific area, there is no doubting this fact: $240 is a number everyone involved with this stock is watching.

Greg Morris, who I like for his thought provoking analysis, only draws horizontal trendlines for exactly this reason.  And even then, he just uses them for understanding the relative points of where the market is.

He states:

I only use horizontal trendlines, those that are represented or defined by price.  And to offer full disclosure I rarely use them for anything other than understanding where the market is, relative to where it was.  In my opinion some of the subjectivity (not all) is removed when you use price for a trendline.  This leads me to why I use horizontal trendlines in the first place.  I strongly believe the market pricing mechanism is a function of supply and demand where the instantaneous view of that supply and demand relationship is the price of a traded security.

That’s a pretty bold statement, don’t you think?

But when you really stop to think about it, a horizontal trendline is more “real” than a sloping trendline.  It’s based on a specific price that is based on transactions between buyers and sellers.  Supply and demand have been rather evenly matched at that horizontal price point and have spent a good bit of time trading at that area.

Buyers and sellers remember this price.  They are focused on it.  Sellers dry up at this price.  Buyers come out in droves at this price.

Greg goes on to mention a human characteristic called anchoring:

Hence, the horizontal trendline is excellent at identifying levels of supply and demand, and hence, support and resistance.  One of the main reasons this works is another of the human frailties called anchoring.  An investor or trader likes to recall the price in which they made a trade, then anchor on it.

One of the reasons why prior resistance becomes support is because of simple supply and demand and this anchoring characteristic.  If you look at that chart again, think about the people who bought at that $240 level after the steep rise in November 2017.  They held on as it declined, holding some heavy bags…all the while focusing on their entry around $240.  They were just hoping to get out, not wanting to be wrong.

When it approached the $240 again, many of these prior buyers got out, adding to supply and stopping the rise.  it took some effort, but eventually the buyers became more insistent and numerous and pushed it beyond that level.

Now, if the price ever comes back to that level, all market participants are again anchoring to that level as a point  where they believe $240 is a “fair value”, buyers come out, sellers dry up.  It becomes a self-reinforcing trendline.

Because horizontal trendlines are based upon price, and only price, they are fairly black and white.  The same can’t be said for sloping trendlines though…

Sloping trendlines are more arbitrary

Drawing sloping trendlines add multiple areas of opportunity to deceive yourself.  They also lack one of the primary factors that a horizontal trendline has, and that is one specific price.

First, a trendline is typically drawn across a series of highs or lows across multiple points.  Check out this chart below.


Once you have at least two price points, you can create your upward or downward sloping trendline.  In this case we have a multiple higher lows that are connected together with the blue trendline that I drew.  But unlike the horizontal trendline, which has just one price to focus on, this trendline has tons of prices.  If you look at it this way, you can connect this blue line by the penny.  The trendline starts at 30.00, then we would have $30.01, $30.02, $30.03…right?  All the way up to $36!  If we want to split hairs that’s 600 different prices from $30 to 36!

So along this trendline, with the market of buyers & sellers, where is their price focus as it relates to the upward sloping trendline?  It’s weak at best.  Is it 30.57?  Maybe 34.03?  🙂  Something to think about.

There are “blank” areas where this stock ver likely traded at all 600 of those price points, but not at the area where the trendline exists.  I highlighted those major gaps with those reddish lines along the way underneath the blue trendline.  As it relates to the scale of this chart, with price on the vertical & axis and time on the horizontal X axis, at the points where the stock was trading away from the trendline, the price moved up faster than the trendline slope.

Speaking of slope,…

Slope can be a pitfall with sloping trendlines

Take for instance these two 4 year price charts of Amazon.

This first chart is logarithmic…meaning that the scale of the vertical price axis is fixed along the entire data series.

In this chart, you can see there were two major contact points, and then the price has started to accelerate in 2017 and 2018 and pull away from the slope of the blue trendline.

Looking at this chart, would it be reasonable to say that AMZN is getting ahead of itself, moving up in price too fast?  Maybe it’s due for a pullback?  Maybe not.

Look at the chart below.

This one has the same pricing data (4 years) for Amazon, but is not logarithmic.

Notice how pricing scale on the Y axis is larger at the bottom and squeezed in tighter towards the top.

That is why in this case, AMZN is sticking to the trendline much more closely.  If you were to analyze this chart, would you say that AMZN is getting ahead of itself?  If you looked at this chart compared to the first chart, one might be more likely to say that no.

I don’t know if AMZN is getting ahead of itself by look at these sloping trendlines.  But simply by changing the way the data is represented on the chart, you can see how visually, it can bias and influence your decision-making.

I don’t think sloping trendlines are any less valid than horizontal lines, but they add extra complexity.  They also lack the focus around a specific price that a horizontal line has.

Something to think about. 🙂

William Eckhardt, of Turtle trading fame, talked about this sort of thing in The New Market Wizards.  He mentioned  how the angle of the trendline can be changed simply by how the chart is designed (logarithmic vs. non-logarithmic).

Some of these are  simple (45-degree angles), and some are harebrained (drawing regular pentagons on the chart), but what they all have in common i the use of angles on a bar chart.  There’s a simple consideration that absolutely invalidates all such angles-of-certain-size methods in a single swipe: The size of an angle on a bar chart is not invariant to changes of scale.  For instance, consider the technique of drawing a line from the low of a move at a 45-degree angle.  If you do this on two charts of the same contract but with different time and price scales, say from two different services, the 45-degree lines will be different.  In fact, the angle of a line joining two prices on a bar chart is not a property of the price series at all.  It depends completely on what units you use for price and time and how you space them on the chart, all of which are quite arbitrary.  There are good methods and bad methods, but these angle techniques are no method.

When I read this years ago, it kind of blew my mind.  It made me think about how we can be influenced simply by the default settings on a chart!  You are letting the chart designer’s arbitrary decision to affect your trading decision.

thinking about these AMZN charts, what if the time series on the X axis was drawn out and stretched?  You could pull it out so far, that the steep climb was a very sluggish, gentle upward slope.  Just something to think about.

One more point that Eckhardt made that I wanted to highlight was this:

The human mind was made to create patterns.  It will see patterns in random data.  A turn-of-the-century statistics book put it this way: “Too fine an eye for pattern will find it anywhere.”  In other words, you’re going to see more on the chart than is truly there.

We need to be careful drawing our trendlines, whether they are horizontal or sloping.  Are we trying to force something that isn’t really there so we can justify making a trade?

Through all of this, are horizontal trendlines better than sloping trendlines?

I don’t think so. However, sloping trendlines do have some extra “moving parts” that a horizontal trendline does not.

  • Since it is a series of price data over a series of time data, we need to be careful about judging whether an angle is too sharp or not.
  • Also, since a sloping trendline does not focus on a specific price like a horizontal trendline, it is lacking that “anchoring” bias that can create extra strength found in a horizontal trendline.

Something to consider though, is the fact that trendlines work because they seem to work.

What the heck to I mean by that?!

If everyone is using the same technical analysis techniques, charts, formulas and indicators, they become self-fulfilling.  They work because they work.

Even accounting for the bias that Eckhardt talks about, at the end of the day, who cares if it isn’t exactly logical?

If everyone is watching and reacting to the same thing…for example: a bounce off of an upward sloping trendline, it happens simply because it’s happened in the past.  Everyone expects the bounce, so it bounces because buyers step in, because they are expecting the bounce.

What are your thoughts on trendlines?

Do you prefer horizontal to sloping?  Do you find them more effective?  Do you trade channels only?  I’m sure I missed a few other key points here, so if you’ve got a few ideas, leave a comment!

Be good & trade safe!

-Glenn

 

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