Lesson of the Day
by Jeff Drake of
Nirvana Systems
Trendline Breaks
When is a Trend Truly Broken?
The importance of trendlines cannot be overstated when it comes
to technical analysis. We are told to trade with the primary
trend, exit when the trend reverses, enter on trend reversals,
and so on. Trends are easy enough to identify, but when is a
trend actually broken?
Ask ten traders and you'll get ten different
answers. This lesson will try and illustrate a few of the
most common techniques used to identify trendline breaks.
The first technique is the easiest to understand
- a trendline break occurs when price penetrates the trendline.
Our first example, AYE, shows that price fell through the
trendline in early May, signaling a trend reversal, and it
continued downward after this move. However, look at February
and March. Aren't these also price penetrations of the trendline?
Yes, and this illustrates the point that most traders consider
a close beyond the trendline to be more significant than
an intra-day penetration of the trendline.
Close price doesn't break the trend until early May for AYE
While this technique is easy to understand,
it lends itself to false signals. Another technique that
waits for more reversal confirmation is to use the Two Day
Rule. The Two Day Rule states that price must close through
the trendline for two successive days. The chart of TXU illustrates
the effectiveness of this rule as price did not close through
the trendline two days in a row until late April.
TXU doesn't close below the trendline 2 days in a row until late April
Another method to validate a trendline break
is the 3% Rule. This rule states that price must close 3%
through the level of the penetration to be considered a break.
The chart for FD shows and example as price closed through
the trendline in December. The point of penetration is 36.50
and the lowest the stock closed was 36.25, so it did not
close 3% from the penetration level and the trend should
be considered still in tact.
The dip in mid-December for FD didn't fall 3% below the penetration level
These three methods represent basic ways of
telling if a trend is reversing. There are quite a few other
methods as well, but basically the best rule of thumb is
not to worry too much about "connecting the dots" and look
for good confirming moves through trendlines. Being late
on a good trade is always preferable to being wrong.
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