The trendline trading strategy is based on the trend following trading method and is an important component of price action strategies. You may have heard Ed Seykota’s famous quote before:
“Trend is your friend until the end when it bends.”
In this strategy, I will show you exactly how to make trend your friend and leave before it bends.
Table of Contents
- What is a trend line?
- How to Draw Trendlines
- Trendline Trading Strategy
- Advance Tips for Trendline Trading Strategy
Trend following is more than just a strategy; for many people, it is a way of life. You see trends developing all around you all the time—fashion trends, technology trends, sports trends, and much more. Let me show you a trend in gold and you will understand what a trend actually means in financial markets:-
Trends are extended periods of directional price moves in either direction in above figure uptrend is shown and move is characterized by higher swings and price continue to move higher however prices can continue to form lower swings also and prices can sometimes move downwards for extended periods of time which is known as downtrend.
Trendline strategy is a powerful strategy based on this fundamental principle of price move, it focuses of two main objectives of trend following :-
- Riding an existing trend
- Exit on trend reversal to book profit
Before we get into strategy, let’s learn more about trendlines and how to interpret a valid trendline, which will ensure a profitable outcome from strategy and increase the likelihood of catching a good strong trend.
What is a trend line?
Trendlines are visual representations of trends in charts; chart reading requires traders to be able to identify price swings in the market and, as a result, trends.
Price swings are classified into two types: swing highs and swing lows. Swing highs occur when the price reaches a certain level and then reverses, while swing lows occur when the price falls and then reverses.
An uptrend occurs when prices move in such a way that each new swing high is relatively higher than the previous one.
Similarly, a downtrend occurs when prices move in such a way that each new swing low is relatively lower than the previous one.
How to Draw Trendlines
Drawing trend line becomes fairly simple when you understand the concept of swing lows and swing highs, To draw a trend line all you have is two steps –
- Identify trend – if two or more swing highs each higher then previous one is formed in chart that confirms an uptrend otherwise if swing highs are relatively low then previous it confirms the downtrend.
- Draw trend line- Connect swing lows of an uptrend ( with a minimum touchpoints of 3) for downtrend connect swing highs
This is how you draw an uptrend and a downtrend line. Remember that the more swing lows and swing highs you can connect, the stronger the confirmation of a trendline will be.
TIP: When connecting swing highs, consider the area of the price swing rather than the absolute body of the candle. This will result in better trend line opportunities. There is no way that a trend line will always appear symmetrical; the goal here is to recognize that a trend exists rather than to improve drawing skills.
It takes time and experience with chart reading to get used to seeing the obvious trendlines, but you should now be proficient enough to recognize trendlines in real-time.
Let us now move onto the trendline strategy.
Trendline Trading Strategy
Trendline trading strategy is very profitable in trending markets and should be used only when a strong trend is visible; choppy markets should be avoided at all costs. There is always some cost associated with any type of strategy and it must be paid to market; in trendline trading strategy, this cost comes in the form of initial trend identification and during trend reversals.
No one can predict when a trend will begin or end, so trendline trading strategy gets all of its “meat” from the middle phase of a trend. During the beginning of a trend and during the phase where the trend reverses, multiple stop losses are hit, which should be considered the cost of trading strategy.
Now let us discuss the real business of trendline trading strategy –
Identifying Trading Opportunities
As explained in the previous section, the first step in trendline trading strategy is to determine whether or not a trend exists.
Once you have determined whether or not a trend exists, you can draw a trendline. There are many opportunities in trend trading, but keep in mind that trend lines are prone to false breakouts and premature entries are always subject to stop loss hunting. That is why it is critical to think of trend lines as an area of importance rather than just a line.
The chart below depicts one such trend line trade opportunity that was executed on 2013 Gold future contracts.
As you can see, the downtrend is confirmed by the second swing high being lower than the first. Connecting these swing points gives us the downtrend line; additionally, two lines have been drawn to represent the area of interest.
When prices approach the trend line area for the third time and then reverse, an entry will be triggered.
In gold futures prices came towards trend line area on 22 Jan 2013 and started to reverse this gave confirmation to trend line and on 24 jan 2013 entry was triggered once daily candle closed below trend line area.
Entry trigger price = 1664
Stop Loss & Money Management
Stop loss for trendline trading strategy is determined by dynamic resistance level of trendline.
Which is nothing more than the trendline itself, which may extend as trading activity continues.
Also to mention here is stop loss itself will be dynamic – moving along with trendline.
The figure above depicts the initial stop loss level of 1700, which is above the value trend line area.
For entry position size, 50% of the quantity will be used, and the remaining 50% of the quantity will be added only when one of the previous support levels is broken, it will ensure good risk reward and better money management.
When the support level of 1640 is broken in a gold trade, the remaining 50% of the quantity is added to the trade.
Targets & Objectives
For trendline trading strategy its better to take three times reward to the risk, usually profit potential is backed by good position sizing rules, it is because of the fact that only 50% of qty is been put to risk when initiating trade and when trade goes in favor adding rest 50% gives a good target potential.
In our example trade, the gold target is almost at the 1:3 risk to reward level and was easily achieved.
Prices surged to 1564 (target) after breaking through the 1640 support level.
Advance Tips for Trendline Trading Strategy
Tips to improve trading with the trendline strategy:-
- Many stop losses have already been placed at the dynamic support or resistance level; placing stop losses at points where there is already a clutter of stop losses may increase the chances of getting caught in a fake breakout from level; in such scenarios, it is better to take market volatility into account and place stop loss slightly above the trendline area.
- Trendlines often have to be adjusted during a long trend, it is a good practice to review recent highs and lows and adjust the trendline formation by prioritizing the recent price move.
- Sometimes trendline strategy gives a very good risk reward, especially when recent support of resistance is broken in such cases you can trail your stop loss rather than just booking profit at target level.
- Use line charts to identify trends, candlestick charts to draw trendlines and placing entry.
- Although you can use the trendline trading strategy with stocks, currency, crypto, or any trending market, the commodity market has had the highest rate of return from this strategy, which could be due to longer-term trends in commodities markets.
Frequently Asked Questions
How to trade trendlines?
Trendline trading strategy helps identify trends and allow trader to place suitable entry, when prices follow a trendline positions are placed in direction of a trend.
Which timeframe is best for trendline trading?
Trendline trading strategy can be deployed using 15 minutes, 1 hour , daily or even weekly timeframes.
Is trendline good for trading?
Trendlines are great way to visualize what market has to offer, they provide better understanding of a market structure and makes it easy for traders to place entry.