Trend lines are one of the oldest as well as most widely used tool to identify a trend. It is a simple yet highly effective tool. However, drawing a trend line is quite subjective. No two people will draw a trend line in the exact same manner. While some prefer connecting the extremes, others prefer connecting the closes. Some even prefer using a combination of the two. There is nothing right or wrong in any of these approaches. What is important to remember is that when drawing a trend line, see that it connects as many points as possible, without a significant and frequent penetrations.
Many people feel that when a trend line is broken, the trend has reversed. This is not necessarily true. When a trend line has broken, it just means that price is no longer maintaining the angle at which it was previously rising or declining. It is important to keep in mind that price could continue moving in the same direction that it was previously moving before the trend line break. Let us understand this using the chart of Nifty.
Above is the Log chart of Nifty on the daily time frame. Notice that the index broke the trend line several days ago. However, see that the index has continued rising even after the break. Let us also look at the Arithmetic chart of Nifty on the daily time frame.
Even on the Arithmetic chart, the index broke the trend line earlier this week, but has since made three successive higher highs and higher lows.
These two charts of Nifty further highlight that trend line breaks do not necessarily imply a trend reversal, but just that price is no longer maintaining the angle at which it was previously rising or falling. This brings me to an important point.
Refrain from acting just on the basis of a signal generated by an indicator or a price tool unless that signal is confirmed by price action itself.
In the above chart of Nifty, it can be seen that since bottoming out in March 2020, the index has steadily been making higher highs and higher lows. Until this sequence of higher highs and higher lows breaks, the uptrend remains intact. First sign of trouble would come when price makes a lower swing high. If it then goes on to make a lower swing low, it would mean a greater probability of a trend reversal. Until then however, the prevailing trend remains intact.
Less frequently however, if the risk to reward ratio is highly favorable, then one can place a low risk bet immediately following the trend line break if there is an expansion in volume. But in this case, do ensure that you trade with a strict stop loss. After all, trading is just one half of the story and risk management is the other, critical half.
Learn more about trend and trend line in the Technical Analysis module on School of Stocks by clicking here.