Of all the technical analysis methods a chartist could use, simple trend lines can be a very useful tool to find short-term support and resistance levels on charts of any scale that you use to analyse. For the beginner trader, looking at a chart for answers as to where the market could likely go or what the market is likely doing in the traders’ desired timeframe can be very confusing and overwhelming.
I explain to all my students that you must have foundation principles that you base all your trading decisions on. One of the principles is: “Can you find any strong price levels of support and Resistance?” To break this down further what I mean is, where is price getting stuck, or where is price failing to penetrate repeatedly. Therefore, support levels are at the bottom of the chart, while resistance is at the top of the chart. Support provides a floor for price, while resistance is considered a ceiling.
The reason we want to find areas of support and resistance is because they give us awesome trade opportunities. We have 4 possible trade entry price levels:
- Buy from strong support.
- Sell at strong resistance.
- Sell if strong support gets broken.
- Buy if strong resistance gets broken.
This is a very simple concept; however, we know that one piece of data or one rule doesn’t make a trading plan. I believe solid foundations behind a trading decision are very important and can give you clarity. One of the most important foundations for chartists is understanding the concept of support and resistance (abbreviated to ‘SR’). There are two simple techniques for identifying SR on your charts.
Firstly, there is horizontal SR. Horizontal SR is defined by marking horizontal zones or lines at price levels where price fails to move higher or lower. Therefore, I look for significant or stand out tops and bottoms on the chart. These price levels are very easy to recognize. Time is irrelevant when identifying these price levels. The frequency at which these price levels act as pivots contributes to their strength. A level is named a pivot, because it describes the market’s reaction at these prices. Basically the market turns direction at these levels.
The second technique falls under the concept of Diagonal SR. The technique of trend lines fall under this category. When the market is an uptrend, you simply start from the bottom and draw a diagonal line up to the higher bottom. We simply require two data points. Quite often in an uptrend we see the price bound between the bottom diagonal line and a top diagonal line that marks the consecutive higher tops. This is what can be defined as trend channel. The market then has diagonal resistance to the high side and diagonal support on the low side, as you can see in Figure 1.0.
There are 2 trade scenarios:
- While trading in the channel, look for buying opportunities off the bottoms and selling opportunities off the tops.
- When the bottom trend line breaks, look for selling opportunities. When the top trend line breaks, look for buying opportunities.
When a market creates two tops and two bottoms sloping up or down, these trend lines create a wedge like structure or what chartists call ‘pennants’. Figure 2.0 shows us ‘Bull Pennant’.
Once again there are two trading scenarios:
- Do nothing. While price stays in the pennant structure, wait until it breaks out.
- Once the market breaks out of the pennant we can look to trade in that direction.
Trend lines are a very simple and time tested way to frame the structure of a market to predict where price may test in the future. All a chartist needs is to be able spot and draw a line between at least two data points. They work on any sized chart for any timeframe. The more experience I gain in the markets reading charts, the simpler my technical analysis and trading rules become. Drawing easy to identify trend lines is one of those tools I use and respect in every chart I analyse. The key tip is that you need to draw trend lines between the clearest to see extreme tops and bottoms. Remember to keep your trading simple.
Cameron Buchanan, a Director and Professional Trader of the International Day Trading Academy