So far, only the possibilities of drawing trendlines joining bottoms in rising markets and tops in declining ones have been examined. It is also useful to draw lines that are parallel to those basic trendlines, as shown in Fig. 4-13. In
Figure 4-12 Up trendline violation measuring objective.
Figure 4-13 Up trend channel.
a rising market, the parallel line known as a return trendline joins the tops of rallies, and during declines the return line joins the series of bottoms (see Fig. 4-14). The area between these trend extremities is known as a trend chan- nel.
The return line is useful from two points of view. First, it represents an area of support or resistance, depending on the direction of the trend.
Second, and perhaps more important, penetration of the return trendline represents a signal that either the trend will accelerate or a reversal in the basic trend of at least a temporary proportion is about to take place.
In Fig. 4-15, the violation of the return line signifies that the price advance has begun to accelerate. In effect, the channel in Fig. 4-15 represents a rising trading range, and the trendline violation is a breakout from it.
Exhaustion
On the other hand, if the angle of the trend channel is much steeper, as in Figs. 4-16 and 4-17, the violation of the return line represents an exhaus- tion move. The failure of the price to hold above (below) the return line then signals an important reversal in trend. This is often the case if the break through the return line is accompanied by high volume.
Consider a situation in which a person is sawing a thick piece of wood.
At first the sawing strokes are slow but deliberate, but gradually the person realizes that this task is going to take some time, becomes frustrated, and slowly increases the speed of the strokes. Finally the person bursts into a
Figure 4-14 Down trend channel.
frantic effort and is forced to give up the task at least temporarily because of complete exhaustion. The same principles hold true in a declining mar- ket. In this case, the expanding volume at the low represents a selling cli- max. As a general rule, the steeper the channel, the more likely it is that the breakout will turn out to be an exhaustion move.
Return trendline
Figure 4-15 Up trend channel breakout.
Figure 4-16 Down trend channel exhaustion break.
Exhaustion also develops when a price rallies temporarily above a regu- lar down trendline (or below an up trendline), then breaks back below (above) it. In the case of a down trendline, the situation is akin to someone jumping up and temporarily pushing through the ceiling. He is able to pull his head through to the next floor for a few moments, but he then falls sharply back to the floor below. At this point he has used up all his spare energy in the attempt to move to the next floor and is totally exhausted.
Before he can make another attempt he will need some time to gain some new energy. The same is true of the price, which makes an effort to rally above the trendline but is unable to maintain the breakout.
This temporary break often indicates that the prevailing trend has much further to run. It also raises a dilemma concerning the way in which a trend- line should be constructed. In Fig. 4-18, for instance, we see a false break above trendline AB. Should ABnow be abandoned, or should the peak of the exhaustion break be connected to the rally high to form a new (dashed AC) trendline? Again, it’s a matter of common sense. On the one hand, the top of the whipsaw break is technically the correct place to draw the line, but common sense suggests that the original line is a better reflection of the underlying trend. After all, at the time of the whipsaw, it had been touched three times. If a new line is then drawn to reflect the break, that line will have been touched only twice, once at the outset and once at the whipsaw peak. In a sense, the whipsaw is adding further credibility to the initial line because the price was unable to hold above it. If we had come upon this situation after the whipsaw break and tried to construct a line, it
Figure 4-17 Up trend channel exhaustion break.
would have been even more obvious that line ABwas far superior to line ACbecause it has been touched or approached on far more occasions.
The same principles are true in reverse for an up trendline. When you think about it, a whipsaw break actually adds credibility to the trendline.This is because the price is able to violate the line, but this line is so significant as
Chart 4-7 Microsoft, 1998–1999, daily.
Figure 4-18 Down trendline construction.
a support/resistance area that the price is unable to hold the break. If it were not such a significant barrier, the break would have held and the whip- saw would have been avoided. Consequently, when the price is able to expe- rience a valid break, the signal is that much stronger.
Chart 4-7 shows an example of a whipsaw downside break for Microsoft in 1998.
Summary
• Trendlines are an easy tool to understand, but they should be used with a strong dose of common sense. Considerable experimentation and prac- tice are required before the art of interpreting them can be successfully mastered.
• Trendline violations signal either a temporary interruption or a reversal in the prevailing trend. It is necessary to refer to other pieces of techni- cal evidence to determine which is being signaled.
• The significance of trendlines is a function of their length, the number of times they have been touched or approached, and the steepness of the angle of ascent or descent.
• A good trendline reflects the underlying trend and represents an impor- tant support and resistance zone.
• Extended trendlines reverse the former support/resistance role and should not be overlooked.
• Exhaustion breaks are usually followed by sharp moves in the opposite direction to the break. Exhaustion breaks enhance the significance of a trendline.
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