Technical Analysis: Trend Lines and Moving Averages
A widely used tool to define a trend is a trend line. A rising or ascending trend line is constructed by connecting the first two higher lows in an uptrend and extending the line into the future.
You need at least two higher lows to connect a rising trend line and extend it as shown on the chart above. The trend line usually acts as a support for the price, as obvious in the third and fourth touch in the above chart.
The opposite goes for a falling trend line. We need at least two lower highs to connect, and the trend line should be treated a resistance.
Trend lines represent the slope of the move or the slope of supply and demand. If for instance, the trend line is very steep, that indicates a strong overwhelming demand compared to supply.
As the trend line represents the slope of supply and demand, a break of it is indicative of a change in the supply/demand trend.
– The steeper the trend line the less reliable it is. And it will most likely be broken quickly. As sharp moves are usually indicative of excessive emotions and in most cases not sustainable.
– The longer the trend line and the more times that the trend line is touched by prices, the more significant it is, and the more significant the reversal when the trend line is finally broken.
– A break of a trend line is merely a warning signal, it doesn’t conclude a trend reversal, but warns of a possible one.
– The breakout of a trend line is one tool that should be used alongside other technical tools and within a broad trading strategy.
Adjusting Trend Lines With The Price Action
Usually, the price penetrates a trend line during the trading session of the time interval under analysis. But never closes the session below or above the trend line, whether it’s rising or falling trend line.
Remember: These intra-day breakouts should be ignored, and the trend line should be adjusted to this newly recorded low.
Also, the trend line should be adjusted following minor false breakouts.
Accelerating and Decelerating Trend lines
A repetitive phenomenon in the Forex markets is the price acceleration and deceleration. It is very common that you see the price trend starts suddenly to accelerate and the upward wave gets sharper and steeper, especially in times of speculative bubbles.
The chart above illustrates this phenomenon, where U.S. Crude Oil futures started a healthy uniform uptrend in early 2017, before starting to accelerate early 2008.
A rising trend line can be drawn for each acceleration. Where a break below the steeper trend line signals a move to the next less steep trend line.
The above chart is an example of decelerating trend lines. This phenomenon is the opposite of the accelerating one. Where the first upward wave is steeper than the subsequent waves. The price decelerates breaking the first rising trend line, but not resulting in a reversal, and moves back higher. A new trend line is then drawn to account for the new trough or peak.
Remember: In theory, the price could repeat this pattern endlessly, but practitioners have concluded that three decelerating lines are the maximum that can be expected before a real sustained reversal.
A channel looks like a rising or falling tube that carries the price motion. It is constructed with two parallel trend lines.
In an ascending channel, two rising trend lines form the channel. The first rising trend line is the main trend line that connects the higher lows, which is the support line. The other trend line is an exact parallel for the first one, plotted starting from the first peak in the trend and projected to the future, and it is the resistance or supply line.
Trend Channels usually contain most of the price action.
In ascending channel the price tends to find demand near the bottom of the channel, while supply increases near the top of channel.
A falling or descending channel is constructed by parallel falling trend line. The upper falling trend line is considered a resistance, while the lower falling trend line is support.
Some chart examples:
Remember: A breakout above the falling or descending channel is similar to breaking a trend line. The outcome is a warning of an upward movement or a trend change.
Remember: Sometimes the price breaks in the direction of the channel. For instance, the price breaks above the rising trend line for the ascending channel. And that could be interpreted as an acceleration of the upward move as new demand is entering the markets.
However, false breakouts are also common, where if the price failed to sustain trading above the channel and moves back within the channel, it is an indication that it might be just a false breakout and the supply/demand slope is back to the prior stage.
Always keep in mind that technical analysis is more of an art than sciences. Don’t be very specific or look for perfection, you will rarely find it. The market may not react exactly at the trend lines every time. Sometimes prices may move a bit higher or lower on an intra-day basis but close on or near the lines.
Moving averages are one of the most popular and reliable tools in technical analysis. It is used mainly for trend determination.
Moving averages are one of the many of what technicians call “Technical Indicators”. Simply what technical indicators do is take the prices and process it in a mathematical equation. Then produce the result on a chart.
There are plenty of them, each one has its unique formula or equation. But, remember that all these indicators are coming from the price it self, it is a source.
Simply a moving average is an average of the -closing- price in the past X periods. It’s calculated each new period and plotted on the chart. The result is a smooth continuous line that represents the price average for that past X period.
A Moving average smooths the erratic price action, and lessen the effect of short term fluctuations. And that helps the analyst focus on the main underlying movement or trend.
Moving averages can be calculated in several methods, the most important and common are the simple and exponential moving averages.
Simple Moving Average (SMA)
The most basic and popular is the simple moving average. And is calculated by a simple arithmetic mean equation.
SMA(n) = Pr1+Pr2+……..+Pr(n) / n
n: Number of periods Pr: Price(usually closing price)
To calculate the 10 days moving average:
SMA(10)= Pr(1)+Pr(2)+…..+Pr(10) / 10
Exponential Moving Average (EMA)
Another popular type is the exponential moving average. The exponential moving average equation gives more weight to the recent data. And that makes it more responsive to the recent price changes. It is said to be faster than the simple moving average.
How To Use Moving Averages in Forex
Using the 10 days moving average is simply like having the general direction for the past group of 10 days.
Having that in mind, choosing a short period will represent the short term trend. While using a longer period, i.e 200 days will give a longer-term view. In that manner, you can focus on the trend that fits the time horizon of your interest.
Moving average are better used on the longer term time intervals. The most common and key moving average periods are:
- 200,100,50,20,10 days
- 52 and 200 weeks
- 12 month
For the short time horizon, the 10,20 and 50 days moving averages are the most useful. While for longer time horizons, the 200 days and 52 weeks are the very reliable.
Moving averages provide the analyst with important information:
- Identify the underlying short, medium and long term trend.
- Two moving averages crossover(one short and one long) is considered a trading signal in mechanical systems or a trend change.
- A moving average often acts as support and resistance.
- Moving averages crossover or intersection level is a support or resistance.
- By comparing the distance between the price and the moving average, you can gauge price extremes. Because moving averages represent the mean, if the current price has deviated substantially from that moving average, the price has a tendency to return to it.
- The price cross of a moving average can be considered a signal.
Remember: The longer the time period of the moving average the most reliable and important support and resistance it is.
Warning: Be confident that a directional trend exists before using a multiple moving average cross over signal. As these crossovers will result in many whipsaws if the price is trading sideways.
Remember: Technical indicators such as the moving averages are called “Lagging Indicators“. This is because the indicator is always lagging the price action. The signals it provides is after the actual price change.