Limitations of a Trend Line

A trend line is a staple of technical analysis. It indicates a stock’s current trend -- up, down or sideways -- that traders use to make timely buy and sell decisions. A trend line's predictive value may be limited, however, as it is often more useful in describing past action than predicting future moves.

Constructing Trend Lines

You draw trend lines on a daily stock chart by connecting two or more recent price tops and two or more recent price bottoms. The upper line is called resistance; the lower line is called support. The angle of the lines indicates whether a stock is in an uptrend, downtrend or moving sideways. The space between the lines is called the trading channel -- that’s where all stock trades take place. Once a stock approaches resistance, it turns lower; once it approaches support, it turns higher.

Validity

The longer a trend line, the more valid it is -- that is, the more likely a stock is to “obey” it by turning when it reaches it, but you can’t trade from the middle of a chart. By the time a trend line becomes a reliable indicator, it may be too late to follow it, because the longer a trend continues, the more likely it is to change course. The new trend line that will emerge will be too short to be reliable until it, too, becomes old.

Penetration

A trend line is penetrated when a stock closes on the other side of it. Penetration may mean an adjustment in a trend line angle or a trend reversal. Trend adjustments are more common, that is why you often see stock charts crisscrossed by trend lines of varying angles and durations: “If this trend line is broken, then the next one is here.” This kind of analysis may sound sophisticated, but it is not very helpful for accurate buy and sell decisions.

Reversal

A trend reversal after a long move in the same direction is the most useful trend line indicator, but essentially you have to wait for a reversal before you can make use of the current trend line, and the new trend line will take time to emerge. For example, a long and steep rise in a stock does not mean an equally long and steep decline when the trend reverses. You may see months of stock bobbing and weaving, evidenced by a multitude of short-term crisscrossing trend lines.

Breakout

A stock breaking above or below an almost horizontal trend line is called a breakout. This often indicates the beginning of a new powerful trend and is one of the most reliable indicators. But many traders trade in the trading channel, between support and resistance, by buying near support and selling near resistance. Short sellers who bet on a stock price going down often sell borrowed shares near resistance to buy them back at lower prices near support. If you buy close to support and the stock breaks down, you lose money; if you sell a stock short close to resistance and the stock breaks out to the upside, you also lose money.

References (1)

  • Technical Analysis of Stock Trends; Robert D. Edwards, et al.

About the Author

Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.

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