Drawing key levels is a core part of technical analysis.
The problem is the technique can be so confusing to newbies, because marking a them on a chart is very subjective!
It is mainly due to the amount of conflicting information out there, traders get really frustrated with getting the process right.
If you give two traders the same chart, and ask them to each plot a line – you will probably see two very different results.
In this guide, I am going to show you my way of drawing a trend line, and give you a demonstration on how I use them.
- What are trend lines used for?
- How to draw trend lines
- Trend Line Reversal Trade Ideas
- Trend Line Breakout Events
- Channel Structures
- The Price Squeeze
- The Megaphone Pattern
- Flag Breakouts
- Trend Line Indicator
What Are Trend Lines Really Used For in Technical Analysis?
These guys are going to pop up in all your ‘chart analysis 101’ text book material.
Their basic function is to highlight linear support and resistance.
Quite often when the market is on the move (making new swing highs and lows), price will tend to respect a linear level – which we identity as a trend line.
Bullish markets will tend to create a rising linear support level…
Notice how all the counter trend movements are terminating at this structure?
When they appear, we can use these lines to anticipate the next reversal point in the market, and look for bullish reversal signals there.
The opposite is true for a bearish scenario…
So obviously the bearish situation is just a role reversal .
Counter trend rallies terminate at clear line as it they as a linear resistance level. We can use it as an anticipate reversal point.
Therefore this common type of technical analysis involves inperpreting these lines as linear support and resistance.
When a line is broken, the market often can come back and re-test it as a new support or resistance level.
Above: An example of one which once held as resistance is then respected as new support as the market pulls back down, and re-tests it.
What I’ve shown so far is the basic functions, but we can do a lot more with them. In the rest of the article, we will walk you through other trend line events such as…
- Counter-trend breaks (flags)
- Classic breakouts
- Example of reversal signals at linear structures
- Consolidation structures created (good and bad)
How Do You Draw Trend Lines – The RIGHT Way?
Firstly, we need to cover a consistent rule-set to encourage (what I believe), is the correct way of identifying quality levels.
Most of the re hashed tutorials out there just instruct you to mark two swing highs or lows together… only two.
This is really crude advice, and can leave you the trader very confused to where to draw the damn line. Tips such as these set traders on the path to extreme over analysis.
Following the commonly preached text bool method (of only using two anchor points), opens up the door for hundreds of possibilities on one chart!
You don’t want that, you need better quality control… other wise you may end up with charts like this…
I know this is an extreme, and humorous example – but I think this guy has connected every two swing highs and lows together…
A line with only two anchor points really just an ‘unconfirmed’ level on your charts.
The example above shows a trend line marked with two swing lows as the anchor points. It is an aggressive, low quality way to go about it.
It is only really a catalyst which may turn into proper level – but at this stage it is just a pending line.
You can mark these pending lines if you think it is appropriate, and wait to see the line is respected again – but most of the time it is just going to clutter your charts, and skew your technical analysis.
The ‘trick’ to drawing quality lines is to use *3* clear anchor points… then you’ve got something worth occupying the real estate of your chart!
When I say anchor points, I mean swing lows or highs that line up in an obvious linear fashion.
See in the chart above, we used 3 swing points.
Using a minimum of 3 anchor points, we build a quality trend line that actually matters to technical analysis.
When you just use two anchor points, your level is basically ‘unclear’, or only partially constructed. You never know if you have it marked in the correct place.
The series of charts below will illustrate the frustration of someone who only uses 2 anchor points…
Seems legit, until…
All of a sudden the market doesn’t respond as expect… better ‘adjust it’, yeah?
OK, now I think I’ve got it…
The comic shows the trader ‘chasing the line’. Which is frustrating and unproductive analysis.
Don’t waste your energy… use 3 anchor points. It’s much easier, and provides a confirmed trend line in the market.
Don’t chase price, mark what you can clearly see!
Above: Using 3 swing highs rule. No more chasing our tail, three data points line up – we’ve got what we need.
Above: The more anchor points we have to build the line, the better – it just becomes more obvious and makes the trend line more significant!
Don’t Let Fake Outs Throw You Off
One thing that throws a lot of traders off, are false breakouts.
We won’t always get the perfect text-book scenario for our charting, false breaks do occur often – making a mess of our picture perfect idea of a trend line.
To ‘filter out’ the fake-outs, I use something which I call the common denominator approach.
The goal is to line up the common data points that create some obvious consistency, and just ‘makes sense’. Let me show an example…
Above: We’ve drawn the line that conforms well with the lows here in a consistent manner. We cut through the fake outs by basically ‘connecting the common dots’.
We can see how the level holds as support here well – the fake out creates an inconvenience we need just to slice straight through.
Let’s look at a bearish example…
Lining up the common swing highs here for identification. The fake out becomes obvious when you work with the consistency of the market.
Marking these out isn’t an exact science, you’re just looking to mark out the general structure so you know when price approaches this important technical level.
Keep the process simple and obvious. If it isn’t obvious and you really struggle to line up the level – then it is probably not a structure level worth worrying about.
Trend Line Reversal Trade Opportunities
Because we know they are anticipated to act as reversal points, we can target reversal trading signals here.
We use candlestick reversal patterns a lot for our trade setups, so we heavily focus on those.
Here is a bullish market example with some candlestick reversal signals…
We had a clear obvious structure here, which was holding nicely as a linear support.
It is only logical to target it for buying opportunities via bullish reversal patterns.
This chart had a bullish outside candle, and a bullish rejection candle (both reversal signals), form off off the level, communicating to us that the the trend line once again was holding as support.
Both trade setups worked out nicely
Check out the chart below…
Above is a nice bearish example, acting as resistance which did see a nice bearish reversal candlestick signal form off it.
The bearish rejection candle signals it was still being respected as resistance, and that we should expect lower prices to follow.
The setup produced a nice sell off!
It is just really simple, logical thinking – just the way I like my trade ideas.
You’ve got a linear line structure where you know price is expected to reverse. Simply combine that with a reversal signal to form your trade opportunity.
Trend Line Breakouts!
We know so far these are key market structures with strong supportive and resistive properties. Whenever some form of market structure is broken, a violent breakout can occur.
A common strategy is to catch breakouts in trend line trading.
There are many ways to do this, but I prefer the ‘close confirmation’ method.
I recommend you wait for for a candle to break through, and close on the other side of the line before reading the situation as a breakout.
The reason for this is because price can often pierce through the line, but not close beyond it. These are known classically as ‘fake outs’, and are notorious around important structures.
Many traders get cremated by fake out events, because they are too ‘trigger sensitive’ and slam the buy, or sell button at the first sign of any kind of sign the market is breaking out.
So we can see price breaking through the line here. Many breakout traders would jump on board this, mostly fueled by greed to try catch the breakout early… but this can come at an expensive cost.
The main point here is the candle hasn’t actually closed yet…
In the chart above – when the candle does finally close, it closes back under – revealing a breakout trap!
Those who were too quick to act have been ushered into a bad position. Now their money has been taken by the market, and flows into the pockets of more disciplined traders.
It is very common for trend lines to be temporarily broken by price, even by just a few pips – only to turn around in the opposite direction.
That’s why trading an ‘in the moment’ breakout is a risky strategy.
When you focus on the candle close, your chances improve of catching a true breakout.
We can see if the pic above, the candle actually closed above the level, indicating a breakout is underway…
The market actually followed through with the breakout move!
This is a good example of waiting for the candle closes gives a much better read on the situation. Trading candles ‘on the fly’ is simply a dangerous game.
Channels are best described as two linear levels that run in parallel to one another.
They look like and sometime are referred to as ‘railway tracks’.
You can get rising, and falling channels.
A rising channel is made from linear higher highs, and higher lows.
The two lines running in parallel create the support, and resistance of the channel structure. Like a ranging market, price bounces between these two lines and reversal signals can be picked off here.
The downward channel is made from two parallel descending lines, which line up lower highs and lower lows.
Reversal signals can be targeted at the channel boundaries. We can see in the pick above that there were some reversal signals at the channel resistance.
They signaled continuation of the channel and were good trade opportunities.
Price Squeeze Consolidation Structures
Linear levels can be used to highlight a consolidation pattern that I call a price squeeze.
It is a scenario where you get lower highs, and higher lows converge in on one another… creating a ‘squeeze’ scenario.
Notice how the higher lows and lower highs created two linear support and resistance levels that converge in on one another.
This ‘compression’ of price is a strong catalyst for a breakout. Generally when the market breaks, and closes outside the squeeze pattern – you get very strong moves.
The above shows the bullish and bearish pressure tightening price into a squeeze, then forcing a breakout.
These patterns can breakout upwards, or downwards, so be prepared!
Watch Out for the Megaphone Pattern!
This pattern is the opposite of a squeeze pattern.
The megaphone is an expansion pattern which can be identified by two diverging lines.
Stock traders know this pattern as the ‘broadening top’, and it shows that the market is increasing in volatility – in an unstable kind of way.
Megaphone patterns are usually created by a market phase called distribution – where big traders are dumping their positions, and violent up and down swings occur.
You will see this pattern on your charts when the market creates higher highs AND lower lows.
Notice how the swings keep becoming larger apart as more and more volatility stacks into the market.
Flag Patterns (Counter Momentum Trend Lines)
The flag pattern is created mainly in a trending environment.
Flags appear when a counter-trend line forms against the prevailing trend momentum. The opposing trend line acts like a dam, holding back the main pressure…
Above: See how the counter trend line backs up the trend pressure. It is the flag break you’re looking for here – a good trend continuation signal.
Flags really work the best in a clear trending environment, and show up more regularly on time frames like the h4 – h8 charts.
Above: Demonstrating the ‘dam wall’ effect here on a bullish market. The upward momentum encounters resistance in the form of a counter momentum line. Once the dam breaks, boom!
Trend Line Alerts With My MT4 Battle Station
I have a ‘trend line’ filter added into the program that will basically alert you to any reversal patterns that form off any levels that you’ve drawn on your chart.
This can be useful if you’re waiting specially for a signal to form off technical points you’ve drawn on your chart…
Above: I set the battle station to only be concern with reversal patterns it detects off levels I’ve drawn on the chart. Notice how it has highlights some reversal patterns at the levels by drawing the tan line through them (colors can be customized)
The battle station can be extra useful here as it will also alert you when it finds these patterns off your t- line.
The alerts come in 3 different ways so you don’t miss a trade:
- Smart Phone Notification
- Email Alerts
- Metatrader Internal Program Pop-up Alerts
More information on the Battle Station can be found here.
Take Home Points From This Lesson
- Trend line analysis can be very subjective – don’t fall into the over analysis trap
- They act as linear support and resistance levels in the market
- Use 3 anchor points to make sure you only draw quality lines
- Use the common denominator method to ‘cut through’ fake outs when drawing trend lines
- Price Action traders can target reversal candlestick patterns at well defined lines
- Watch for when a candle closes beyond a clear line for breakout trade opportunities
- Lines that run in parallel to each other create channel structures
- Converging lines create price squeeze patterns – a potent breakout catalyst
- Diverging lines create a high volatility pattern called the megaphone!
- Trend lines that form against trend momentum can create the flag pattern (dam wall effect)
- Watch for candles to close beyond the flag pattern as a trend continuation signal
Hopefully you’ve enjoy this tutorial!
In the comments below, please let me know what you thought, or if you would like me to expand on any of the topics discussed here.
If you would like to learn more about trading with trend lines using candlestick reversal, and candlestick breakout patterns – check out the war room for price action traders.
I wish you all the best on the charts!
Don’t forget to leave your comment 🙂