The Use of Trend Lines and Charting Patterns in Trading the Forex Markets The use of Trends and Trend Lines forms the basis of establishing the support and resistance levels and charting patterns that are used in trading Forex. Trend lines are also the basis of Breakout trading a technique used to establish the entry level for the trades that are placed on the trading station. Trends and Trend Lines One of the basic concepts of technical analysis is the tendency for prices to move in a particular direction for a certain period of time, known as the trend. The old adage that applies to technical analysis is The Trend is your friend. The art of trading Forex is to establish the trend and then to use the changes in trend for buying and selling decisions. We always want to be trading in the direction of the trend. The concept of the Trend leads us to the study of the use of Trend lines as an analytical tool. This is one of the market techniques that you are going to use as a trader. Next to Cycles, Trend lines are probably the most valuable and accurate tool at the disposal of the trader. They are especially useful for the confirmation of cycle turning points. As I have pointed out prices move in trends. These trends may be up, down or sideways. They may be brief or they may last for an extended period. Sooner or later trends change. They may change by reversing from up to down or down to up. They may also change direction without reversing. Thus, for example, a trend may alter from up to sideways and then to up again. If the Trend is moving upwards we want to be long of the market and if the Trend is moving in a downward direction we want to consider selling or going short.
In the 60 minute graph of the pound dollar below, up trends, a down trend and a sideways trend are clearly seen: At the start of an analysis the trader examines the graph for support and resistance lines and charting patterns. You can make trading decisions using the support and resistance levels especially when they are combined with the direction of the cycles and their turning points. Support and resistance levels are seen virtually on any time frame from end of day prices all the way down to 5 and 1 minute periods The basic rule is that 3 connecting points are needed to constitute a Trend Line. A resistance line connects the tops of the prices in a straight line. Every time the line is touched the currency reverses as the sellers come in. It is a level where the price fails to go any higher. The line is penetrated if the buyers get the upper hand. A support line connects the price lows. As the price approaches the line buyers come in to lift the Forex security off the line. In effect it bounces off the line. If the sellers get the upper hand the support line is penetrated.
This 60 minute graph of the Pound Dollar demonstrates support and resistance lines: The graph of the Pound Dollar clearly demonstrates the value of parallel support and resistance lines. Parallel trend lines are more reliable than angled lines and the longer they remain in place the more valid they become. The resistance line at the top of the graph capped a further rise in the pound dollar while the lower trend line acted as valid support. We now come to the concept that a support line when penetrated can become a line of resistance. Here is a good example in a 15 minute candle sticks chart of the Pound Dollar where the support line is penetrated at A to become a line of resistance. The GBP/USD attempts twice to penetrate the resistance at points B but the line holds:
The above is an important concept when trading as once a support line is penetrated the trader knows that it could become a line of resistance and could be traded eventually for a downward bounce off the line as in seen in this graph. The opposite applies as when a resistance line is penetrated the chances are that the price will move back to this line, now acting as a support level. So to sum up: The trader has to decide, when a price is approaching a support or resistance line, whether the line will hold and a bounce will take place from the line or penetration take place through the line. The trend of the cycles will determine the decision. We now come to Channels. This pattern plays an important role in trading. Channels are patterns that develop from price action that takes place between support and resistance lines These lines are confirmed when they have been touched at least three times. Channels tell you two things: 1. That the price is likely to keep trading in the channel once it is formed. 2. If one of the lines is penetrated the breakout is usually significant. We can trade the bounces or the breakouts that can take place from the channel lines. A channel can be parallel or sloping either in an ascending or descending direction. So you can trade long or short in a channel. Long - when it bounces off the support line and Short - when it bounces down off the resistance line. Conversely we can go long when the resistance line of the channel is penetrated and short when the support line is broken through. Channels are often seen in the smaller time frames. Here is example of the multiple channels seen in the 15 minutes candle sticks graph of the Euro dollar. The breakouts from these channels alone could have been used for trading. Note that the more often a security trades up and down between the channel lines, the more significant the eventual upside or downside breakout.
CHARTING PATTERNS Leading on from channels we come to Charting patterns.these are pictures or formations that appear on price charts of stocks, currencies or financial instruments and like cycles, have predictive value. There are two major categories of price patterns reversal or continuous. Reversal patterns can indicate that an important change in trend is taking place. The most well known reversal pattern is the head and shoulders pattern. Regardless of the type of pattern the point of breakout is meaningful to the trader. This becomes more significant when the breakout is accompanied by a cycle turning point. This accompanying graph of the Euro Dollar shows breakouts from head and shoulders, reverse head and shoulders and triangular patterns. Double bottom and top reversal formations are also clearly seen in the graph In the lower cycle graph note how the cycle peaks at the Y points concur with the tops of the price pattern of the Euro/$ in the top graph and the cycle low X points with the bottoms of the price. The charting pattern that has practical application in Forex Trading is the Flag Pattern, a continuation pattern Continuation patterns suggest that the market will continue on its course. Using them in conjunction with cycle indicators is recommended. The two primary continuation patterns that develop when a security is in a strong trend are flags and pennants. Pennants are basically the same as flags except that its borders diverge whereas the borders of a flag are parallel. Flags and pennants typically represent pauses in a major trend. These patterns are usually followed by price swings in the same direction as the previous trend.
Here are examples of the flag pattern in the trading of a 60 minute chart of the Euro Dollar. The flags appear in this chart as the lines A to B. A break out from a flag or pennant is a confirmation that the trend is continuing and is a trading signal in the direction of the trend.