Trendline: What It Is, How to Use It in Investing, With Examples

What Is a Trendline?

Trendlines are fundamental charting tools used by traders to depict the prevailing direction of an investment's price. By connecting a series of prices either over pivot highs or under pivot lows, trendlines offer a visual representation of support and resistance levels across various timeframes.

This technique provides valuable insights into price direction and speed, as well as patterns during periods of price contraction, aiding investors in making informed decisions about market trends.

Understanding Trendline Insights in Technical Analysis

The trendline is among the most important tools used by technical analysts. Instead of examining past business performance or other fundamentals, technical analysts focus on price trends. A trendline helps technical analysts determine the current direction in market prices. Technical analysts believe the trend is your friend, and identifying this trend is the first step in the process of making a good trade.

To create a trendline, an analyst must have at least two points on a price chart. Some analysts like to use different time frames such as one minute or five minutes. Others look at daily charts or weekly charts. Some analysts put aside time altogether, choosing to view trends based on tick intervals rather than intervals of time. Trendlines are universally appealing because they help identify trends regardless of the time period, time frame, or interval used.

 If company A moves from $35 to $40 in two days and then to $45 in three days, the analyst can plot these three points on a chart. If the analyst draws a line between all three price points, they have an upward trend. The trendline drawn has a positive slope and is therefore telling the analyst to buy in the direction of the trend. If company A's price goes from $35 to $25, however, the trendline has a negative slope and the analyst should sell in the direction of the trend.

How to Apply Trendlines: A Practical Example

Trendlines are relatively easy to use. A trader simply has to chart the price data normally, using open, close, high and low. Below is data for the Russell 2000 in a candlestick chart with the trendline applied to three session lows over a two month period.

The trendline indicates an uptrend in the Russell 2000 and acts as support when entering a position. A trader might enter a long position near the trendline and extend it into the future. If the price action breaches the trendline on the downside, the trader can use that as a signal to close the position. This helps traders exit when the trend begins to weaken.

Trendlines are, of course, a product of the time period. In the example above, a trader doesn't need to redraw the trendline very often. On a time scale of minutes, however, trendlines and trades may need to be readjusted frequently.

Comparing Trendlines and Channels in Chart Analysis

More than one trendline can be applied to a chart. Traders often connect highs and lows with trendlines to create channels. A channel visually represents both support and resistance for the analyzed time period. Similar to a single trendline, traders watch for a spike or breakout to move the price action out of the channel. They may use that breach as an exit point or an entry point depending on how they are setting up their trade.

Recognizing the Limitations of Trendlines

Like all charting tools, trendlines need readjustment as more price data comes in. A trendline may last a long time, but eventually, price action deviates enough to require an update. Traders often select different data points: some use the lowest lows, while others prefer the lowest closing prices. Last, trendlines applied on smaller timeframes can be volume sensitive. A trendline formed on low volume may easily be broken as volume picks up throughout a session.