Charts are pictorial representation of psychology of traders. It shows the actions of the bulls and the bears.
Bottoms of declines (downmove) show where the bears stopped and the bulls regained control of the markets and peaks of rallies (upmove) show where the bulls stopped or bears gained upperhand in the markets. When I say declines or rallies, I am referring to the price.
When we connect two or more bottoms by a line or when we connect to or more tops, we get trendlines. When we connect bottoms, we get an upward slanting line and when to connect tops, we get downward slanting trendline. Downward incline means an down trend and upward incline reflects uptrend. Traders use these line to determine trends, supports/resistance and trend reversals.
The most important feature of an trendline is its angle. Trendline represents the dominant market force (bulls or bears). Trendlines helps in determining uptrend, downtrend or an rangebound market.
When trendlines points upward, it reflects the bulls are in control and we can use it to buy on dips near the trendline supports and put an stoploss just below the trendline or we can close the trade once the trendline breaks. Similarly we can sell short when trendline points downwards near the trendline resistance and put a stoploss above the trendline resistance.
Trendlines are very old tool and at present we can use moving averages, directional systems, MACD etc. See the image below:
How to draw a Trendline
Many draw a trendlines through extreme high and low points, but it is better to draw it through the edges of congestion zones. Those edges reflect where the majority of traders have reversed directions or we rather say where the fight for supremacy took place.
Technical analysis is like taking a poll and the polltakers want to track the opinion of the masses and not a few extremists.
Drawing trendlines through the edges of congestion areas is somewhat subjective. You always look for the temptation to slant your ruler.
Panic dumping by bulls at the bottoms and panic covering by bears at the tops create extremes, which appear as long tails on the charts.
Edges most of the time reflect panic and not the actual picture of the crowd behaviour. Panic is when traders are dumping/exiting their positions to cut losses and save whatever is left of their capital or these are created by margin triggers in the future and options segments.
These extreme points are also very important but for those short term traders. It also at times reflects point of reversal of prices. Here we can use the longer term charts to determine shorter time frame price anticipation and trade accordingly. I will discuss this in more details in upcoming blogs.
Markets constantly fluctuate, seeking an area that generates the highest volume of trading. A tails shows that a certain price has been rejected by the market. It usually leads to a swing in the opposite direction.
As soon as you recognize a tail, trade against it. Place a protective stop halfway through the tails. If the market starts chewing its tail, it is time to get out.