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This column is devoted to technical analysis, which studies the supply and demand for securities
This column is devoted to technical analysis, which studies the supply and demand for securities
based on price activity and trading volume. Charts and indicators are used to uncover patterns that
may point to future price movements.

resistance. There are two types of trendlines—the up trend and the down trend.

upward price movement.

Down Trendline

A down trendline has a negative or

downward slope that is formed by connecting two or more high points. The second high must be lower than

the first in order for the line to have

a negative slope (lower lows and

lower highs). Figure 2 shows a down trend. Extending the line forward pro-

vides an estimate of future resistance levels. During down trends, supply

is increasing relative to demand even

as prices fall. A declining price with

increasing supply is a bearish sig- nal; the down trend remains intact as long as prices remain below the down trendline.

A break occurs in the down

trendline when prices move above it, indicating that supply begins to wane relative to demand. Such breaks above the down trendline may indicate that a change in trend is im- minent. However, it is a good idea to wait until the price establishes higher bottoms before drawing a new up trendline.

Validation

As we said, it takes two or more

points to draw a trendline—up trend or down trend. How- ever, when looking to draw trendlines,

the temptation is to merely draw them through extreme

high and low points.

It is better to draw

a trendline through

points where the price has momen- tarily pulled back and reversed direc- tion. The more times prices “touch” the trendline, the more “valid” the line becomes as a level of support or resistance.

Without two points,

Trendline

Basics

Sometimes it feels like computers can make things more complicated than they really need to be. One case in point is technical analysis. With affordable computers available to the masses, it seems like the battle be- tween software makers is to see who can pack the most features into their programs. However, sometimes the most simple of analysis techniques can be just as useful as the most complex indicators. Trendlines are one of hallmarks of technical analysis. This makes sense,

given that technical analysis is built on the premise that prices trend. Well-known technician John Murphy wrote this about trendlines in his book “The Visual Investor”: “The simple trendline is possibly the most useful tool in the study of market trends. And you’ll be happy to know that they’re extremely easy to draw.”

Up Trendline

An up trendline has a positive slope, meaning it rises as you move from left to right on the chart. An oft-used definition of an up trend is higher highs and higher lows. Typically, up trendlines are formed by connecting two or more low points on a chart. The key is that the second low must be higher then the first in order for the line to have a posi- tive slope. Figure 1 illustrates an up trend. Extending the up trendline into the future provides a good indication of future support levels. As long as the trend is up, demand is outstripping supply even as the price rises. In- creasing demand in the face of rising prices is a bullish sign and as long as prices remain above the trendline, the up trend is considered intact. Eventually, there will be a break below the up trendline. This occurs when supply begins to outweigh de- mand. Breaks below the up trendline indicate a change in trend could be coming. Once the up trendline is broken, chances are it may become a level of resistance that stifles further

In this installment of Technically

A trendline is a straight line that

connects two or more price points. Extending this line into the future, it also acts as a line of support or

Speaking, we discuss the basics of

trendlines and how you can use them in your investing.

Figure 1. Up Trendline

the basics of trendlines and how you can use them in your investing. Figure 1. Up

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Computerized Investing

you cannot draw a trendline. There- fore, it is not always possible to create a

you cannot draw

a trendline. There-

fore, it is not always possible to create a trendline.

Figure 2. Down Trendline

possible to create a trendline. Figure 2. Down Trendline Figure 3. Internal Trendline points sparingly, as

Figure 3. Internal Trendline

Figure 2. Down Trendline Figure 3. Internal Trendline points sparingly, as the more points you ignore

points sparingly, as the more points you ignore to fit the trendline, the less meaning the line carries. The long-term trendline for Potash Corp. (POT) in Figure 3 extends upward from August of 2007 and passes through the lows in January 2008 and March 2008. These lows were formed with selling climaxes and represent extreme price move- ments that protrude beneath the trend line. By drawing the trendline through these lows, the upward trendline matches better with the

other lows over this period.

Conclusion

Trendlines are a simple way to illustrate the trend of the market or an individual security. However, like any technical analysis tool, they can generate false signals if they are not used properly. Furthermore, trendlines should not be your sole decision-making tool. Using other technical indicators can help you confirm whether a change in trend is taking place.

help you confirm whether a change in trend is taking place. Spacing The spacing of the

Spacing

The spacing of the lows used to form an up trendline and the highs used to form a down trend- line should not be too far apart, or too close together. The “proper” distance between points will largely depend on the timeframe used with the chart, as with all price movement. Ideally, trendlines are made up of relatively evenly spaced lows or highs.

Steepness

The steeper the trendline, the less valid the support

or resistance level

it represents. Steep

trendlines are caused by sharp advances or declines over a short time period. Prices that are moving

upward or down- ward rapidly cannot be sustained in a trend; eventually prices will move below or above the trendline.

“Internal”Trendlines

There may be times when you are drawing a trendline that the highs and lows will not match up exactly, perhaps because the angle of the trendline is too steep or the points are too close together. In these cases, you may be able to draw “internal” trendlines that ignore one or two points. However, you should ignore

Third Quarter 2009

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