Basic Trading Concepts defined
Trend lines and trend channels are excellent tools for measuring and monitoring market direction and sentiment. Trend lines capture the very core of price movements by connecting multiple hit points which allow Forex traders to distinguish patterns and trends. Forex traders can use trend lines for a wide variety of purposes such as:
1. Capitalize on opportunities in the Forex market
2. Exact trade decisions (entry, stop loss, take profit)
3. Trade management (trail stop loss movement)
4. Monitor for breaks
5. Monitor for bounces
6. Filter out setups with less probability
7. Determine the trend
8. Identify chart patterns
9. Generally as support and resistance levels
A trend line is a line which connects multiple highs or lows on a chart. The best trend lines have 3 hits or more. A trend line with 2 hits is in theory a potential trend line. When connecting the highs and lows, the trend line either has no angle (horizontal line) or various angles varying from shallow to steep. Read more here about the differences between horizontal and angled trend lines.
A trend channel consists of 2 trend lines, one connecting tops and one connecting bottoms. The best channels have 3 hits or more as well; a channel with 2 hits is not yet “established”. The angle of the bottom and the top of the channel are equal to each other.
Forex traders need to take the trend line key and start connecting 1 point with another. Usually a bottom is connected with another support point; whereas a top is connected with another resistance point.
The trader can repeat the process and place multiple trend lines on one chart (same pair and time frame); there is really no limit as long as the trader can manage to read and understand the chart. The trader can draw more trend lines on other time frames as well for additional information (if the trader uses multiple time frame analysis). Here is an example of a chart “overloaded” with trend lines:
Forex traders usually use 1-3 trend channels on all time frames. The main reason is practical: channels with parallel lines at the top and bottom are rarer than trend lines because both sides need multiple hits. The process of drawing a channel is the same as drawing a trend line, with one major difference: traders need to check the accuracy of both lines.
Once a Forex trader starts drawing trend lines, the chart could quickly fill up with trend lines in dozens of directions, which defeats the importance of keeping trading simple and effective. In the next section I will show you how to examine trend lines and decide which ones have the most value.
There are multiple ways Forex traders are able to identify better trend lines. Here is the list:
1. Relevance or proximity to price
2. Number of hits
3. “Neatness” of a trend line
4. Broken lines
5. Distance between hits
A trend line that is “miles” away from current price levels is not relevant for current analysis or trade setups and therefore will only clutter the charts. The best practice is to place lines on the chart which are not too far away and have a chance of playing a role in your analysis or plan.
Trend lines with 2 hits are usually not interesting unless price is close by. In these cases there is a chance that price will hit the trend line and “respect” it, which in turn creates a 3rd hit (and therefore becomes an “established” trend line). If price is far away then trend lines with 2 hits can be ignored for the time being.
Trend lines with 3 hits or more are the most interesting trend lines. These trend lines are “established”, which means the market confirms the existence of this support or resistance line. These trend lines create decision spots on the charts.
The best trend lines connect the high and lows of candles with each other. However if a Forex trader follows this guideline then many trend lines would have only 2 hits. To increase the number of hits on a trend line, Forex traders need to decrease the neatness of a trend line by not only using highs and lows of candles. This means that trend lines “cut” through part of the candle. Preferably only the wick of a candle is placed beyond the trend line but even placing part of the candle outside the trend line perimeter is acceptable. However, in most cases, placing an entire candle or group of candles on the opposite side of the trend line is not accepted and would make the trend line less valuable.
In many cases broken trend lines will eventually be removed but it is a good practice to be patient and leave the broken trend lines on the charts for a while. Often the market retests broken trend lines and they offer extra confluence points.
A new hit on the trend lines is only counted when there is sufficient distance between 2 hits. A new hit is not valid if the candle high or low is too near the previous high and low. In the most extreme example, traders cannot count a trend line to have 2 hits if the candles are next to each other. The fact that both candles hit the trend line counts as 1 hit.
Reference: Chris Svorcik