In the previous blogpost, I explained how to identify whether the stock is in an Uptrend or a Downtrend. This week, let’s jump into how to use Trendlines to identify the points where a stock trend changes from Uptrend to Downtrend/Sideways and vice versa.
What are Trendlines?
Trendlines are nothing but straight lines connecting the Higher Lows in an uptrend and the Lower Highs in a downtrend. Do read this blogpost, if you would like to understand more about Higher Lows and Lower Highs.
Trendlines are the easiest concept technical analysis has and will ever have. They are very simple to draw and they signify the underlying trend. With trendlines, it is very easy to spot the key price points where a stock’s trend changes and can provide significant gains with the least possible risk.
Even a 10-year old kid can draw a trendline just by looking at the price. However, many a times we tend to complicate it. Hence, it is important to keep it simple. Now let’s look at how to draw them.
How to draw Trendlines?
There are a few key principles when it comes to drawing trendlines.
Major Principle: Trendlines must connect at least two or more points. The greater the number of touch points, the more significance the trendline will have.
To draw a trendline, first identify a major bottom/low point in the stock price and connect it to the next Higher Low point and extend this to the right.
Drawing Trendlines in an Uptrend
I have taken the example of Asian paints on the Monthly charts to explain this. Notice how the major low point is connected to the 2nd HL point and when extended to the right, notice how it connects to other HL points perfectly.
Identifying the Primary Trendline
A significant trendline will have at least three touchpoints or more. When you connect the major low point to the 2nd HL point and extend this to the right, this creates the primary trendline which signifies the primary uptrend.
A primary trendline with 6 touch points as seen in Asian paints is much more significant than a trendline with just two touchpoints.
When price breaks this primary trendline, the stock trend is said to have changed. In the case of Asian Paints, the break of the primary trendlines means the Primary uptrend is said to be over for the time-being. This also means that the stock will start a downtrend or go sideways, depending on how strong the selling is. In the above example you can see how Asian paints price broke below the primary trendline and started a downtrend.
So, if there is a Primary trendline, should there be something called a Secondary Trendline too?
Identifying Secondary Trendlines
Yes, there is also a Secondary trendline that can form when the price starts to race away from the primary trendline and makes a bottom far away from the primary trendline and then starts to form Higher Lows. The Secondary Trendline is drawn similar to the primary trendline, but connecting the first major low point that is far away from the primary trendline to the next Higher Low point.
Secondary trendlines usually form when there is a strong change in perception of the company and there is too much demand for the stock resulting in a steep move up followed by consolidation and starts to form Higher lows.
Drawing Trendlines in an Downtrend
The same principles can be applied to trendlines in a downtrend. Below is an example of Wockhardt.
To draw a trendline that identifies a downtrend, connect the highest point to the next Lower High point and extend the trendline to the right. Observe how the Primary trendline is drawn with this principle.
In order to draw the secondary trendline, identify the LH point that is far away from the Primary trendline and connect the next LH point to the right and you should be able to draw the Secondary trendline.
After the price broke out from the secondary trendline in Jan’18, the price raced towards the primary trendline for the third time and reversed. This downward sloping primary trendline now becomes very valid and significant because there are 3 touch points.
Finally, the price broke out from this significant primary trendline in Dec’20 and started moving upwards. Now, we can safely say the downtrend is complete and a possible uptrend can take the price higher.
Key take away
I hope this explanation helps you to learn to draw trendlines and identify when trends change.
The key take-away from this blogpost is: Never buy a stock for investment that is not able to move above the primary trendline.
There are few more key principles which make a trendline significant. I will cover these principles in my next blogpost.
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