By Richard Krugel
Updated October 4th, 2019
Introduction: How to Draw Trend Lines Correctly
One of the simplest technical drawing tools is the trend line and traders use them as a visual marker that can indicate a trends direction or serve as a warning sign that a trend is about to change direction.
Formulating a strategy that is solely based on a trend line however is probably not going to yield successful results but like so many other technical drawing tools they work much better when combined with other methods to form a rock solid strategy.
The purpose of this article is to share with you some trend line trading tips and offer you a glimpse of how I use them personally in my own trading.
Back to Basics
Before I show you how I use trend lines, let’s quickly have a look at how they should be drawn on a chart in both an uptrend and downtrend.
Our first chart example shows a very clear uptrend in Gold that lasted for half a year back in 2016. Using a 4 hour chart I drew two trend lines which shows how the angles of these trend lines have changed as price moved upwards during that period.
When you are dealing with an uptrend a trend line should be drawn underneath the trend by connecting the higher lows with each other.
When a new trend starts the angle of a trend line is generally pretty flat (black line) and should be updated through the life cycle of the trend. When that trend experienced a period of strength (black arrow), it was reasonable to expect a period where price would snap back.
After price moved lower during a corrective phase and broke the high again that caused the correction it was time to use another trend line and update it at a steeper angle (blue line).
That blue trend line worked very well at indicating a change in trend as soon as price broke below it at the area marked with the red arrow.
After the uptrend there was a period where Gold moved strongly downwards again and a black trend line could have been drawn connecting the lower highs with each other again forming a pretty flat angle.
When price experienced a strong dip, away from the black trend line it was time to assume that price would snap back higher again. In our example price tested the black trend line again and soon after dropped strongly lower breaking the low that created that corrective phase which would require that we update the angle of the trend line once more.
Readers may notice that the updated blue trend line cuts through that long wick that tested the black trend line. This was necessary because if we used the highest high of that wick we would have been left with a very flat angle that was similar to the first black trend line angle.
There is a bit of subjectivity when drawing trend lines but all you have to remember is that they should adapt to price action and be constantly updated to visually define what the trend is doing.
Because of this subjectivity it makes it almost impossible to only use trend lines as a way to trade but when combined as part of a strategy that relies on other methods then they become very useful.
Using Trend Lines in a Strategy
What follows will be a brief glimpse of how I combine trend lines with other methods to create a powerful strategy. My strategy has only one goal:
Find the end of corrections within a trend and enter low risk positions when the main trend resumes again.
That goal is of course easier said than done, so to achieve it I need a strategy that is aimed at doing the flowing:
- Determine trend or a change in trend
- Find areas where a correction is most likely to occur
- Identify the type of correction that is occurring
- Use market geometry to find where that correction is most likely to end
- Enter low risk trades following a rules based set of entry conditions.
The 5 steps above follows a systematic approach to find the end of corrections within a trend with a high degree of accuracy.
Step 1: Determine Trend
My very first step requires the use of trend lines to determine trend or a change in trend and the chart of Crude Oil above serves as a great example. Crude Oil has been in a strong uptrend since late June 2017 but it wasn’t until my downward sloping trend line was broken to the upside that it signaled a warning that there could be change in trend to follow.
In addition to my trend lines, I also like to use a red horizontal line drawn on top of previous market structure to act as more confirmation that a new trend has possibly started, so when both my trend line and previous market structure line gets broken do I start anticipating a change in trend and my directional bias would then change to the long side.
Step 2: Find Areas Where a Correction May Occur
Step 2 requires that I find areas where a correction is most likely to occur and a good way to do this is to use your Fibonacci extension tool and connect it to previous major swings within the same trend.
The idea is that price will find resistance at those extension ratios and cause a correction to develop which is exactly what I am waiting for before proceeding to step 3. The red arrows on the chart above shows how corrections developed at those ratios.
Step 3: Identify the Type of Correction
The chart above shows a larger type of correction that appeared at the 1.382% Fib extension. Making a serious study of corrections and the type of repeatable characteristics that they display has helped me tremendously through the years to pinpoint the most likely areas where they may end before the main trend continues again.
Once I have a correction confirmed I next zoom into price action a bit closer on a time frame lower than the one I used before to identify my trend on. I follow a few very specific correction types and the one above is called a Double ZigZag and by knowing how they tend to behave like, it becomes easier to label them in a way that identifies them better.
This is a crucial exercise because all I’m doing is anticipating what these type of corrections tend to look like which in turn helps me to know at which stage of development they are in.
Step 4: Use Market Geometry to Find the End of the Correction
Step 4 is where the magic happens and attempts to find the most likely area where the type of correction I’m looking at should end. A Pitchfork is a technical drawing technique that is classed as a method of market geometry and works well to define future price movement and where price is most likely to find support and resistance.
The blue lines of a pitchfork are called median lines and the red lines are called warning lines and through the years I have found that corrections love to end around the red warning lines with a high degree of accuracy.
If you look closely to how I applied the pitchfork over price action you may note that price ended above the lower red warning line and not at it! Knowing how to adapt your pitchfork connection points to market structure is crucial step.
When using market geometry there are no definite rules and traders who use such techniques should allow price action’s interaction with market geometry be their guide.
By simply shifting the lower anchor point of the pitchfork to the lowest closing price after wave C, it became evident that price’s interaction with the median lines of the pitchfork became almost perfect. This time around the red warning line acted as the termination point of this entire correction.
Sometimes, it’s easier than this and a pitchfork can work perfectly well when used on very obvious anchor points. The thing to take home here is that you should watch prices interaction with the pitchfork’s median lines to guide you in your decisions.
Knowing that a Double ZigZag was most likely to end below the (W) labelled point and at the lower red warning line was a powerful thing to know and prepare for ahead of time.
Step 5: Entering Low Risk Trades
The last step in the process is to actually enter a trade but only after a set of very specific conditions appear on the chart. I like using an even smaller time frame to search for entry signals and to keep my risk to the minimum.
On the chart above is a MACD Histogram which I use to spot momentum divergence or a decrease in selling pressure in this case. This is one of the entry conditions I need to see and the second one is the presence of a reversal type candlestick formation at the area I’m interested to trade from.
The appearance of these two conditions, right at the lower red warning line of my pitchfork signaled a trade entry was necessary a few ticks above the reversal candlestick.
Entering slightly above that reversal bar got me long with only a 15 tick stop loss.
My targets are generally placed around levels close to where the correction started from and can sometimes be nail biting stuff to wait until they are reached. Trading multiple contracts do allow me to take earlier partial profits but in the end IF I was correct about a correction ending THEN price should eventually take out the high from where the correction originated from.
This was one of those trades that netted a profit vs. reward ratio of over 17:1! Having the patience and the skills to execute trades like these is what I live for and enjoy about my approach.
This article only briefly touched on the steps I take to find the ends of corrections. How to draw trend lines correctly only played a small part of the entire strategy but served a crucial purpose.
If you ever wondered what it takes to obtain similar results like these on a consistent basis, be sure to check out my full strategy here.
I wish you the best of success on your own trading journey and hope that you gained some better insight on how to draw trend lines correctly.
All the best,