Trendlines & Channels: Charting Terminology

After having discussed the basics of Support and Resistance, today I shall talk about how to draw and follow trend lines. Sometimes these trend lines give us what we call a "Channel" on the charts. I shall discuss both these concepts in this article. Also, as usual,  I will show you how I used this concept in the last one year in trading ICICI bank stock and also Nifty Futures sometimes. 

Trend Lines can simply be drawn by joining the bottoms formed during an uptrend or by joining the tops during a down trend. Thus, this concept is applicable for any stock which is in medium to long term uptrend or down trend. It may also work in the very short term, but for that one needs to use smaller time frame charts, say a 15 minute or a 30 minute chart. For the purpose of understanding I shall be drawing trend lines for medium to long term trends and hence will use daily time frame on charts. 

Below is the 2 year chart of the Nifty 50 index which I have used to draw trend lines. I have taken a 2 year chart as I wanted to cover both downtrend and a uptrend. 

Nifty Daily for 2 years ( Zerodha charting software)

As you can very well see in the chart above, there is a falling trend line that I have drawn on the left hand side of the chart. But how did I do it? 

1) You need at least two points (point A and B in above case) to draw a trend line. This is of course just common sense ;)

2) While drawing a trend line, there must be a "trend". Well, this is the important part. So, in a down trend you would want the chart to show a "lower top lower bottom" formation (top B is lower than top A and every subsequent bottom is lower than the previous one). Similarly, in a uptrend, the charts should show a "higher top higher bottom" formation as seen on the right hand side of the chart.

How to trade once a trend line is drawn? 

Most important part of trading with trend lines is following the trend. So, if the charts shows a down trend, wait for the opportunity to short sell a stock. In the above chart, once we have drawn a trend line using points A and B, we are then waiting for an opportunity to short the Nifty every time it comes close to this trend line. The RED arrow (next to point B in the chart) indicates a short selling opportunity. Nifty shall face resistance here due to the presence of the trend line. This is called Trend Line Resistance. You can see, how shorting the nifty at that point of time for a medium term time frame would have yielded handsome returns. Also, the risk-reward at this trend line resistance is very favorable. One can keep a stop loss if the trend line resistance is broken convincingly by say 60-70 odd points in case of nifty.

Similarly, a trend line can be drawn in a uptrend using points D and E (higher top higher bottom formation). Once, the trend line has been drawn, the green arrows in the chart show all the buying opportunities available for a trader. These points are thus called Trend line Support and hence offer great risk reward for a trader to go long. 

Another interesting part is, what happens if the trend support or resistance is broken? Well, this more often than not signifies a reversal in the existing trend. So, a break below the trend line support, denoted by point F in the chart, is a reversal signal. It signifies that the existing uptrend has been broken and one may now exit long positions, or may even take a short position, depending upon ones risk profile.

We can apply the above mentioned concept to any highly traded asset. ICICI bank in the last one year gave me some decent opportunities to trade using this concept. 

                                                          ICICI Bank Daily for 2 years ( Zerodha charting software)

From the above chart it is visible that ICICI Bank was in a clear downtrend in the year 2015 (left hand side of the chart). It faced resistance every time it moved towards the resistance trend line. However, it was in April 2016, when it finally broke above the trend line resistance, thus causing a reversal in the existing downtrend. In the next couple of months, ICICI bank moved A-B-C-D (higher top-higher bottom formation), thereby confirming a start of an up trend. A trend line was drawn using points B and D. Every time the stock came close to this trend line support (green arrows), it was a buying opportunity and yielded good 10-15% returns in a matter of a less than a month.

When to book profits? 

More often than not, a trend line support is accompanied by a channel resistance line. A combination of the two lines is called a channel. This channel may be parallel, as in the above case of ICICI Bank, or it may be converging or diverging channel (often called a wedge). In the above case, by joining points A and C,  we get this upper channel resistance line. This line can be used by traders to take profits from the long positions.

One may wonder if this upper channel resistance line can be used to take short positions too? Well, the answer depends on your risk profile. It may be dangerous to short a stock which is in a uptrend. The best trade often is to go with the trend, than against it. 

I hope this helps. Best way to learn such concepts is to open charts and start drawing trend lines. If you need a free charting software, check out www.tradingview.com

Cheers!