In the previous blogpost, I wrote about how to identify changes in trends using trendlines. However, the question we most often ask is- what is the importance of a specific trendline that is drawn?
There are three main rules that can be used to determine the importance of the trendline. We will take the example of the Nifty chart since the COVID crash to explain the rules.
Rule 1: Time Period of the Trendline
In the example below, you will notice that Nifty had a short term fierce move up after the COVID crash and the upward sloping trendline (from point A to point B) here lasted for only 1.5 months. The initial move after a bottom is always fierce and that is the main reason why the trendline drawn is shorter in length and is bound to break. This is also because short term traders tend to book profits resulting in a trendline break.
The shorter the time period of the trendline drawn the less significant it is and it might not really signal a massive change in trend. A shorter time trendline break might just mean a consolidation phase before the price starts to move up again
The next trendline (from point A to point C) is drawn connecting the bottom made after the 1.5 month trendline break, and this was a 5 month trendline. The break of this trendline meant a change in trend compared to the break of the 1.5 month trendline. This is purely because this trendline duration was much higher.
The below Nifty chart has a 15 month trendline and a break in this could be very significant because the duration is much higher compared to the other two.
Rule 2: Number of Touchpoints
Any trendline with 3 or more touchpoints is a very significant one.
A trendline needs two points to be drawn. In the Nifty 1.5 month trendline there were only two touchpoints. So, it is not really a significant one. However, the 5 month and the 15 month trendline had 3 touchpoints, or in other words, the price approached the trendline 3 times and reversed. So, both of these trendlines have a much higher significance compared to the 1.5 month trendline. However, the 15 month trendline is much more significant because it has a higher duration(15 months) and 3 touchpoints.
Below is another example of Aarti Drugs. The price approached and tested the trendline for the third time during the COVID crash. However, since the price reversed now from this trendline and since it had 3 touchpoints along with a duration of 11 years, this trendline becomes very significant.
Rule 3: Angle of the Trendline
The steeper the angle of the trendline, the more easily it will be broken. The less steep the angle of the trendline, the more significant it is and is more likely to be respected.
From my experience, any trendline with an angle greater than 30° is steep and is more likely to be broken before the previous trend continues.
In the above example of Aarti drugs, you can see how easily the steeper trendlines are broken and after that you either see a sideways consolidation or a short term correction before the price goes up again!
However, if the 15° angle trendline is broken, it is more likely to change the trend of this stock- from uptrend to downtrend.
Key take away
The key take-away from this blogpost is: When looking for a significant trendline, you want the trendline to be longer in duration with at least 3 touch points and at an angle that is not too steep.
I hope this explanation helps you to identify the significance of a trendline using these 3 main rules.
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