A quick lesson on trendlines and what they can tell us about market dynamics. Take a look at a fairly long-term chart of the Dow Jones Industrial Average (below) with trendlines doing back to the low in early 2016. First, notice the light little trendline that ends in late 2016.
Why does this trendline end? Because price action at the end of 2016 invalidated the line. The line was broken decisively, and once a line is cut or broken we don’t have any good reason to expect it to be meaningful in the future. (In other words, it’s a mistake to carry this line forward.)
Now look at the dark trendlines. These were drawn according to the same, consistent rule set I published many years ago in my book (and in this blog). A valid trendline:
- Is drawn from a significant pivot low to
- A pivot low that precedes a new trend high.
- The line may not cut prices in between those attachment points.
Next, a parallel trendline (trend channel line) was reflected and positioned according to this rule:
- The parallel trendline is attached to a pivot high in between the two attachment points for the lower trendline.
- The parallel trendline may not cut prices in between those attachment points (though it may later).
Notice what we can learn from these properly drawn trendlines:
- The trend channel did (and often does) an outstanding job of containing the trend through 2017.
- When price pressed above the channel line in late 2017, this was the first evidence that the market was going into an overheated phase.
- The February 2018 collapse has merely pulled the market back within the trend channel. This move is still consistent with the intact uptrend.
So far, this looks like a relatively healthy correction in a market that saw some over exuberance and became at least short-term overbought. Of course, trends do end through those parabolic buying climaxes, so we must watch subsequent action carefully.
One of the advantages of publishing daily research as I do for Waverly Advisors and MarketLife is that I’ve created a real “point in time” journal of my thoughts and analytical tools over the years. It’s fascinating to see the power of simple tools like this, when they reflect growth, psychology, and other market dynamics.
(Edit: my work is now available at Talon Advisors.)
Take a few moments to check out those old blog posts and to see if this simple rule set for trendlines can help you in your own trading and analysis.
