Trendlines - Uptrend

There are two types of trendlines, the uptrend and downtrend. An uptrend is established by higher highs and higher lows over time. In contrast, a downtrend is established by lower highs and lower lows over time.

An uptrend is shown visually on a chart by a support trendline. The support trendline is drawn on a chart using the lowest low followed by the next lowest low. This only requires two prices touching the support trendline; however, there is much conflict among traders whether a third touch of the support trendline is required for the trendline to be valid. Rockefeller (2011) states that "experience shows that your trust is better placed in a trendline with three or more touches. . . You're taking more risk if you accept two touches" (p. 171). The number of touches of the trendline to prices increases the effectiveness of the expected future breakout. Kirkpatrick & Dahlquist (2010) give the trading maxim: "the longer and the more times that the drawn line is touched by prices, the more significant it is when the line is finally broken" (p. 242). Bulkowski (2005) mirrored that conclusion when he stated, "I concluded that the more touches, the more powerful the decline after the trendline breakout".

Support Trendline Sell Signal and Possible Buy Signal

The main buy/sell signal given with an uptrend is that when prices break and close below the support trendline, a sell signal is given. However, care must be taken because some big traders like to push prices below an uptrend for a day in order to buy up what other traders are selling; this is called a false breakout. Rockefeller (2011) suggests traders look at the price bar prior to the breakout bar below the support trendline and see whether prices closed near the high of the price bar (chances are the following day's breakout is false) or near the low of the price bar (chances are that the following day's breakout is real) (p. 173).

The support trendline can be used for buy signals as well, Rockefeller (2011) points out that some traders buy when price bounces up off the support trendline the third time (p. 172).

Support Trendline Typical Timespans

Bulkowski (2005) suggests that the typical time distance between trendline touches is about 28 days, with a total median time before a breakout of 137 days.

Average Maximum Breakout Decline

Bulkowski's (2005) research concluded that the breakout below support averaged a 16% drop when support line touches were less than or equal to four.

Trendlines - Downtrend

A downtrend is shown on a chart by a resistance trendline. The resistance trendline is drawn on the highest high followed by the next highest high. Two highs connecting is all that is required for a valid trendline; however, three lower high touches is recommended.

Resistance Trendline Buy Signal

A buy signal is triggered when prices break and close above the downward sloping resistance trendline. In contrast, a sell signal is triggered when prices fall off the resistance trendline for the third time.

Resistance Trendline Typical Timespans

Bulkowski (2005) suggests that the typical time distance between trendline touches is about 29 days, with a total median time before a breakout of 139 days.

Average Maximum Breakout Gain

Bulkowski's (2005) research concluded that the breakout above resistance averaged a 33% gain when resistance line touches were three; 38% with four trendline touches; and 57% with five trendline touches.

Price Targets

To calculate the price target of a trendline breakout, use the following formulas given by Bulkowski (2005):

Traits of Trendlines that Increase Effectiveness of Buy and Sell Signals

The traits that increase the effectiveness of the buy/sell signals of the support and resistance trendline are given next (Bulkowski, 2005):

• The more times price touches the trendline, the more powerful the eventual breakout move will be.
• Larger time separation between price touches of the trendline usually means the eventual breakout move will be more powerful. For downtrend touches, the median is 29 days, for uptrend touches, the median is 28 days.
• Longer trendlines typically mean stronger declines after prices breakout beyond the trendline. The median length for upward sloping support trendlines is 137 days; for downward sloping resistance trendlines is 139 days.
• Shallow trendlines (45 degrees or less) are more reliable than steep trendlines (60 degrees or more).

Uptrend Support Trendline Chart Example

The chart above of the S&P 500 ETF (SPY) shows a support trendline in an uptrend with three price touches of the trendline. The first false support trendline was broken only 31 days into the trend which is far below Bulkowski's (2005) suggestion that the trend be over 137 days and there was only two touches, not the suggested three touches to make a valid uptrend. The eventual support trendline was broken 134 days later and the touches of the uptrend were separated by 35 days and then 65 days.

Downtrend Resistance Trendline Chart Example

The chart above of the Dow Jones Industrial Average ETF (DIA) illustrates a resistance trendline in a downtrend. The chart shows the first false breakout being 44 days which is far below the median suggested by Bulkowski (2005) of 139 days. Note that the distance between the peaks creating the temporary resistance trendline were 11 days and then 4 days; this is nowhere near the median time spread suggested by Bulkowski, which is 29 days. The next false breakout occurred after 110 days and the spread between the peaks creating the temporary resistance trendline was 49 days and then 19 days. The final downtrend resistance trendline was 259 days with peaks spread out 125 days and then 76 days. The final breakout was a large price bar that closed near the price bar's high.

Works Referenced

1. Kirkpatrick II, C.D., & Dahlquist, J.R. (2010). Technical Analysis: The Complete Resource for Financial Market Technicians (2nd ed.). Upper Saddle River, NJ: FT Press.
2. Rockefeller, B. (2011). Technical Analysis For Dummies (2nd ed.). Hoboken: John Wiley & Sons.
3. The Pattern Site. (2008). Bulkowski's Measure Rule. Retrieved June 1, 2012, from http://thepatternsite.com/measure.html
4. The Pattern Site. (2005). Bulkowski's Down-Sloping Trendlines . Retrieved June 1, 2012, from http://thepatternsite.com/trenddown.html
5. The Pattern Site. (2005). Bulkowski's Up-Sloping Trendlines . Retrieved June 1, 2012, from http://thepatternsite.com/uptrendlines.html