Trendlines and channels
A trend line connects successive lows or highs. It helps bring order to a chart, but it's easy to draw it so it fits your own opinion.
Learning objective: After this lesson you can draw a trend line and judge where its limits are.
You connect two lows with a line and extend it to the right. If the price touches it again later and turns up there, the line counts as confirmed. Two parallel lines form a channel.
The problem with trend lines
That's a useful tool for bringing order to a picture. It just has one problem you should know about: you decide which points to connect.
Too many possible lines
With twenty candles there are a great many possible lines. If you look long enough, you'll usually find one that looks good. That's why chart analysis seems more convincing in hindsight than in a live market.
A simple test
A simple test helps. Draw the line and then cover the right half of the chart with your hand. Would you have drawn the line the same way without that knowledge? If not, you've already built the result into the line.
A trend line is a straight line through selected highs or lows. You choose the points and the scale yourself, so there are a great many lines that all look plausible. With ten lows there are already 45 possible connections between two points. In hindsight you pick the one that fits later turning points. That's exactly overfitting: choosing after you already know the result.
Free choice of scale
The scale is a free choice too. A line that's straight on a linear scale is curved on a logarithmic one and vice versa. Over longer periods with a strong rise, the two views lead to quite different statements, and neither is the right one according to the method itself.
Using trend lines testably
If you want to use trend lines in a testable way, you have to fix everything beforehand: what counts as a high or low, how far apart the points must be, how many touches are needed, how much tolerance is allowed, which scale you use and what counts as a break. Only then can you test the method on old data. Without these rules, a trend line is a way of presenting a chart, but not a method.
Summary
- You choose the points, and that's exactly where the weakness lies.
- Linear and logarithmic scales give different lines.
- Without rules fixed beforehand, it's a presentation, not a method.
Did you get it?
Why does chart analysis seem more convincing in hindsight?
Because the lines are chosen after the result is already known. That's overfitting.
What role does the scale play?
A line that's straight on a linear scale is curved on a logarithmic one. The two views lead to different statements.
What turns a trend line into a testable method?
Rules fixed beforehand for highs and lows, touches, tolerance, scale and what counts as a break.
Check your understanding
Your task
Open a chart of your choice, draw a trendline through two lows, and cover the right half with your hand. Would you have drawn the line the same way without knowing the rest? Also work out how many connections between two points exist among 12 lows.
Related
- Support and resistanceStage 4
- Fundamental vs. technical analysisStage 4
- Reading a chartStage 4
- Matching questions for this stageQuestions