Trading the Line How to Use Trendlines to Spot Reversals and Ride Trends eBook EWI eBook Trading the Line — How to Use Trendlines to Spot Reversals and Ride Trends By Jeffrey Kennedy, Elliott Wave International Chapter 1 - Defining Trendlines Find out what a trendline is and what it represents. Chapter 2 - Drawing Trendlines Learn how trendlines identify resistance and support. Also, find out how to draw trendlines, how to spot trendline breaks and what a triple fan trendline looks like. Chapter 3 - Trendline Trade Setups Discover why trendline gaps and retests are Jeffrey Kennedy’s two favorite trendline trade setups. Chapter 4 - Trendlines and the Wave Principle Find out how the pros utilize trendlines in conjunction with the Elliott Wave Principle. Also, throw under and throw over are defined. Chapter 5 - The Kennedy Channeling Technique Jeffrey Kennedy explains his own channeling technique, which is a simple way of drawing trendlines that also helps identify Elliottt waves. Chapter 6 - Questions and Answers Jeffrey Kennedy answers questions asked by Trading the Line webinar participants. Introduction My name is Jeffrey Kennedy, and I’m the editor of Future Junctures. In Trading the Line, I will explain several important aspects of trendlines, including how to define them and utilize them to identify trade setups. Specifically, in this eBook, I will cover the following topics: the definition of a trendline; what a trendline represents; types of trendlines; techniques for drawing trendlines; trendline trade setups; the Wave Principle and trendlines; and the Kennedy channeling technique. Editor’s note: This webinar was originally presented live in January of 2008. 1 Trading the Line — How to Use Trendlines to Spot Reversals and Ride Trends © 2009 Elliott Wave International — www.elliottwave.com Chapter 1 Defining Trendlines Before I define a trendline, we need to identify what a line is. A line simply connects two points, a first point and a second point. Within the scope of technical analysis, these points are typically price highs or price lows. The significance of the trendline is directionally proportional to the importance of point one and point two. Keep that in mind when drawing trendlines. Figure 1-1 A trendline represents the psychology of the market, specifically, the psychol- ogy between the bulls and the bears. If the trendline slopes upward, the bulls are in control. If the trendline slopes downward, the bears are in control. Moreover, the actual angle or slope of a trendline can determine whether or not the market is extremely optimistic, as it was in the upwards sloping line in Figure 1-1 or extremely pessimistic, as it was in the downwards sloping line in the same figure. Now we’re on to the fun part – draw- ing trendlines. You can do this several different ways. You can draw them horizontally, which identifies resis- tance and support. Or, you can draw them vertically, which identifies mo- ments in time. You primarily apply vertical trendlines if you’re doing a cycle analysis. 2 Trading the Line — How to Use Trendlines to Spot Reversals and Ride Trends © 2009 Elliott Wave International — www.elliottwave.com Figure 1-2 You can also map trendlines at an angle, like you see in Figure 1-2, which identifies price and time. There’s really not a wrong way to draw a trendline, which is why trendlines are a simple, crucial tool. Chapter 1 Key Points • A trendline represents bull market versus bear market psychology. • Trendlines exhibit how optimistic or pessimistic the markets can be. • Horizontal trendlines identify resistance and support. Vertical trendlines identify moments in time. Diagonal trendlines identify both price and time. 3 Trading the Line — How to Use Trendlines to Spot Reversals and Ride Trends © 2009 Elliott Wave International — www.elliottwave.com Chapter 1 — Defining Trendlines Chapter 2 Drawing Trendlines Figure 2-1 In this section, I’ll show you how I draw trendlines. I’ll start with the most common, simple way to draw them. Just connect two extremes, two highs in this instance, to identify resistance, as seen in the line in Figure 2-1. Figure 2-2 Another way to draw them is connect- ing lows, to identify potential support. For this example, refer to Figure 2-2, which shows a price chart of Google. If you connect the lows in this chart, you might be surprised what develops when that trendline is extended. 4 Trading the Line — How To Use Trendlines To Spot Reversals and Ride Trends © 2009 Elliott Wave International — www.elliottwave.com Figure 2-3 In Figure 2-3, that one little trendline between the lows in 2004 and the lows in 2005 consistently provided sup- port for a number of retracements, or counter trend movements, within the advance in Google since then. When you’re drawing trendlines from low to low, you can do something else with them that I find pretty interesting. Oftentimes, I like to identify the low extremes within a move and then take a parallel. In the example shown in Figure 2-3, look at the trendline from the lows within the advance in Google, take a parallel of that line off the ex- treme – the highest we’ve seen – and you can see the most recent peak in Google, the upper line, provided resistance. It was just a simple trendline drawn on the lows and extended upward in a parallel line off the intervening extreme. Figure 2-4 Next, in Figure 2-4, look where the up- per boundary line provided resistance of the trendline. Notice there is another use for it. The midpoint of the trendline provides resistance in four different areas, which is why I include the center point or the midline when I draw paral- lel trendlines or price channels. 5 Chapter 2 — Drawing Trendlines Trading the Line — How To Use Trendlines To Spot Reversals and Ride Trends © 2009 Elliott Wave International — www.elliottwave.com Figure 2-5 The price chart shown in Figure 2-5 is of coffee, and again, I’ve already drawn a trendline on it. I connected the two extremes, points labeled 1 and 2, which provided support for points labeled 3 and 4. Figure 2-6 Let’s look at another example in Figure 2-6, a cotton weekly chart, to exem- plify how useful trendlines can be. I’ve connected the lows, points 1 and 2, and taken a parallel off the extremes of the price move at point 3. This shows how a simple trendline identifies resistance in cotton. This is why you should draw trendlines – because one drawn some months ago, some days ago, some weeks ago, even some years ago can still be applicable today. This one little trendline in the previous figure, drawn from one low to another low, was ef- fective on more than one occasion. 6 Chapter 2 — Drawing Trendlines Trading the Line — How To Use Trendlines To Spot Reversals and Ride Trends © 2009 Elliott Wave International — www.elliottwave.com Figure 2-7 Notice the resistance it provided in Figure 2-7. Note: For an additional example, see Slide 32 of Jeffrey Kennedy’s online trading course Trading the Line — How to Use Trendlines to Spot Reversals and Ride Trends. Figure 2-8 Trendlines are probably the most basic analytical tool you can apply, whether it’s a stock, currency or commodity; yet, they’re extremely effective. More often than not, two parallel lines con- tain counter trend or corrective price action. Usually, it provides support, and you see prices either reverse near the lower boundary line or the center line. As you can see in Figure 2-8, the lower boundary line provided solid support for a subsequent move up in prices. 7 Chapter 2 — Drawing Trendlines Trading the Line — How To Use Trendlines To Spot Reversals and Ride Trends © 2009 Elliott Wave International — www.elliottwave.com Figure 2-9 Now, here’s a neat little trick. In Fig- ure 2-9, we use trendlines a different way. By connecting the two lows, we distinguish the breakout point. Later, it provides support when prices revisit the same line (circled). Figure 2-10 Or, we can connect the highs and take it from an intervening low, as seen in this soybean weekly chart. The reversal that occurred in price at the lower boundary line is circled. 8 Chapter 2 — Drawing Trendlines Trading the Line — How To Use Trendlines To Spot Reversals and Ride Trends © 2009 Elliott Wave International — www.elliottwave.com Figure 2-11 Most of the lines that I’ve drawn thus far have been from high to highs, tak- ing parallels off intervening lows, or they’ve been from low to low, taking parallels off intervening highs. That’s not the only way to draw trendlines. Case in point – look at Figure 2-11. We connected the two lows, and it provided support in Google for the subsequent events shown. However, there was another way to identify sup- port in this stock without drawing the traditional low-to-low trendline. Figure 2-12 You could have drawn the trendline by connecting the highs and then taking the parallel off the intervening low, as shown in Figure 2-12. The circled area shows support. 9 Chapter 2 — Drawing Trendlines Trading the Line — How To Use Trendlines To Spot Reversals and Ride Trends © 2009 Elliott Wave International — www.elliottwave.com Techniques for Drawing Trendlines Figure 2-13 I’ve explained how to draw trendlines from extremes – from high to high and low to low. In Figure 2-13, I drew two trendlines from significant highs to a significant lows. Upon first glance, the initial trendline does not provide the analyst or trader with much informa- tion. However, if you draw a trendline from a significant high to a low, or vice versa, and take a parallel of that trend- line to the most extreme point within the move, you might discover if the trend will break or continue. Figure 2-14 For example, I’ve drawn a trendline from a significant low to a significant high in Figure 2-14. I then take a par- allel of that line off the lowest move within the price sequence. That trend- line identifies the end of one trend and the beginning of a new one. As soon as prices began closing below the trend- line, the previous move was done. 10 Chapter 2 — Drawing Trendlines Trading the Line — How To Use Trendlines To Spot Reversals and Ride Trends © 2009 Elliott Wave International — www.elliottwave.com Figure 2-15 Figure 2-15, a weekly bond chart, shows another example. Draw a trend- line from the high to the low, take a parallel of that line and move it over to the most extreme move within the decline. Penetration of this line signals the completion of this decline Figure 2-16 Look at Figure 2-16, which is the same weekly bond chart as before. Draw a trendline from the low to the high, take a parallel of that line, move it over to the right, to the most extreme portion of that move. You now know what prices must do to signal the onset of a new trend. Note: For an additional example, see Slide 54 of Jeffrey Kennedy’s online trading course Trading the Line — How to Use Trendlines to Spot Reversals and Ride Trends. 11 Chapter 2 — Drawing Trendlines Trading the Line — How To Use Trendlines To Spot Reversals and Ride Trends © 2009 Elliott Wave International — www.elliottwave.com Defining Trendline Breaks Figure 2-17 In Figure 2-17, a much shorter-term timeframe is illustrated in a 60-minute price chart of the E-Mini Dow. Draw a line from the low to the high then take a parallel to the most extreme portion of the move. When prices begin break- ing below this line, the previous move is done. Figure 2-18 You can utilize this approach with much sharper moves as well, such as the decline in Figure 2-18. When prices begin moving above it or closing above it, then that’s a good indication the previous move is done. 12 Chapter 2 — Drawing Trendlines Trading the Line — How To Use Trendlines To Spot Reversals and Ride Trends © 2009 Elliott Wave International — www.elliottwave.com Figure 2-19 Question: When is a trendline break a trendline break? Some people think closes above or below trendlines in- dicate a trendline break. I prefer to see price action begin moving above or below a trendline on a high or low basis. For example, in Figure 2-19, we see some closing price action below the lower trendline which I don’t really constitute as a legitimate break of the trendline. Not until the high of the bar is below the trendline (where the pencil is pointing), is there an actual break of the previous trendline. Figure 2-20 Let me readdress the question to make my point clear. What constitutes a legitimate trendline break? Well, in this instance, in Figure 2-20, I’m not looking for closing price action below the trendline, but rather the high of the price bar forming below the trendline. In this instance, we did close below the trendline (marked with the short line and pencil). However, two or three price bars later, the high of the bar is actually below the trendline. 13 Chapter 2 — Drawing Trendlines Trading the Line — How To Use Trendlines To Spot Reversals and Ride Trends © 2009 Elliott Wave International — www.elliottwave.com Figure 2-21 Let’s go back to a previous example. When the high of the price bar is below the trendline, it signals a sell off to the downside. Figure 2-22 The lows of these price bars in Figure 2-22 were above the secondary trend- line and that confirmed the previous move was done. 14 Chapter 2 — Drawing Trendlines Trading the Line — How To Use Trendlines To Spot Reversals and Ride Trends © 2009 Elliott Wave International — www.elliottwave.com