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 trades 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.
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.
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.
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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Close price doesn't
break the trend until early May for AYE
TXU doesn't close
below the trendline 2 days in a row until late April
The dip in
mid-December for FD didn't fall 3% below the penetration leve
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