How to Properly Draw Trendlines

September 15, 2014

The New Market Wizards: Conversations with America's Top TradersĀ  by Jack Schwager is one of those classic books about the capital markets that every trader and investor should read. I think the interview with Victor Sperandeo is one of the best about equities trading and technical analysis. Here's an excerpt which has greatly helped the way I draw charts and find trendline patterns:

What is the correct way of drawing a trend line? In the case of an uptrend line, you draw the line from the lowest low to the highest low immediately preceding the highest high, making sure that the connecting point you select does not result in the trend line passing through any prices between the two points. Once the trend line is broken, I then look for an unsuccessful test of the recent high. This failure may take the form of prices reversing below the previous high or, in some instances, prices might actually penetrate the previous high by a modest amount and then break. In the case where prices penetrate the previous high, a pullback below that high would serve as confirmation of a failed test of the high. The third and final confirmation of a trend change would be the downside penetration of the most recent relative low.

In my observations of applying trendlines to my own charts, I also notice that the steeper the slope of your trendline, the sooner it is likely to break. A trendline with less slope tends to correlate with bigger, longer term moves in prices. When figuring out entries or exits for my trades using trendlines, I often redraw them to better fit what I'm seeing with the latest price action.