The Importance of Basic Trading Tools - Especially the Trend Line

In some of the Kitco Education stories I have written, I discussed my "primary" trading tools and my "secondary" trading tools. I also mentioned that the more tools one has in his or her "Trading Toolbox," the better the odds for trading success. In this educational feature, I want to focus on one of the most basic--yet most powerful--trading tools: the trend line.

As a refresher, I'll reiterate that my "primary" trading tools are basic chart patterns, such as triangles, double-tops and bottoms, head-and-shoulders formations, flags, pennants, etc.--and of course, trend lines. I also consider fundamental analysis of a primary trading tool. My "secondary" trading tools are the computer-generated technical indicators, such as moving averages, Slow Stochastics, MACD, RSI, DMI, etc. Volume and open interest in futures markets are also categorized as my secondary indicators.

I believe that cash and futures traders can still be successful without the aid of computer-generated indicators. Two of the most famous and successful traders never touched a computer--Jesse Livermore and Richard Wyckoff. When I first got into this fascinating business, I had no computer to give me an RSI or DMI or moving averages. I had a weekly chart service that was mailed (U.S. Postal Service, not email!). On the markets I was following, I plotted the daily high, low and close on the daily bar chart and drew trend lines with a ruler and pencil. For the longer-term monthly and weekly continuation charts for nearby futures, the chart service would send out updates about once a quarter.

I'm sure there are still a few traders who use paper charts and still trade successfully. Certainly, the evolution of computer trading and charting software the past 30 years has made technical analysis much easier. But the point I make here is that while computers have made the chore of technical analysis and charting easier, they have not made trading success any easier.

In the 1990s the "neural networks" were the buzzwords in futures trading. Magazine articles espoused the wonders of using "artificial intelligence" to virtually do your all of your trading for you. That fad seems to have come and gone--thank goodness! Now, the "back-to-basics" approach to trading has regained popularity. (To many of us, this approach never lost popularity!)

Before discussing trend lines, I want to share with you one anecdote, regarding all those computer-generated technical trading indicators. Many of them remind me of the pliers I got for Christmas a couple years ago. These pliers were touted as a break-through wonder tool that does it all. However, in reality, when you've got a tough nut or bolt to loosen, you head for the toolbox and your trusty old box-end wrench or vise-grips. In trading, my box-end wrenches and vise-grips are the basic chart patterns that you can plot (by hand if you have to) on a chart.

Now on to the venerable trend line. Here is what respected technical analyst John J. Murphy says about trend lines in his excellent book, Technical Analysis of the Futures Markets: "The importance of trading in the direction of the major trend cannot be overstated. The danger in placing too much importance on oscillators, by themselves, is the temptation to use divergence as an excuse to initiate trades contrary to the general trend. This action generally proves a costly and painful exercise. The oscillator, as useful as it is, is just one tool among many others and must always be used as an aid, not a substitute, for basic trend analysis."

On drawing trend lines on the charts, the methodologies vary--and there are really no hard and fast rules. Like much of technical analysis, drawing trend lines is more art than science. When drawing an uptrend line, you draw a straight line up to the right along successive "reaction" lows. A downtrend line is drawn to the right along successive rally peaks. It's important to note that the more times the rally peaks or reaction lows touch the trend line, the more powerful the trend line becomes. The rule I use for the negating of trend lines is that prices must penetrate the trend line resistance or support level--and then see follow-through strength or weakness the next trading session. However, if prices make a big push above or below the trend line, then that trend line is negated without needing follow-through confirmation.

There are also strong price trends that occur without an actual trend line being drawn, or which a trend lined drawn does not match up well with the “reaction” highs on lows. These trends are still just as valid as those price trends that match up better with a trend line drawn.

Importantly, remember, too, that market prices can trend in three directions: up, down and sideways. In fact, it can be argued that most of the time, most markets are trending in a sideways and choppy fashion.

John Murphy's book, which I mentioned above, has much more detail on trend-line analysis as well as other basic chart patterns.


Read more by Jim Wyckoff