Support and Resistance
An important concept in the use of trendlines is that of support and resistance. A continued trend is based on underlying support for prices in the market, for whatever reason. Similarly, there’s resistance to higher prices built into the market. The trendline is one way to capture and illustrate these zones of support and resistance.
As long as the market stays within these zones of support and resistance, as shown by a trendline, the trend is sustained. Any penetration through a trendline warns of a possible change in trend. We may not know the reason behind such a change, but we do know that for some reason the support or resistance for a market is changing.
The Rhino Theory of Support and Resistance: The upper and lower trendlines contain the price the way a barbed wire fence might contain a rhino. Think of the prices as the rhino and the trendline as a barbed wire fence. If a rhino leans against the wire, the fence will give a bit, offering more and more resistance until either the rhino eases off or the wire snaps. If the rhino has wandered along and leaned against the fence in several places without breaking through, we will have more faith in the strength of the fence.
If the rhino only leaned against the fence once before moving along, it is less meaningful. In charting practice, a line based on one high or one low means nothing. Two highs or lows is the bare minimum. The more points you can connect the more significant the resulting line. And, the more significant the trendline, the more significant any penetration will be. (I say will be because all trends eventually reverse some day!)
Another aspect of resistance and support concerns the round numbers associated with price levels, such as 10, 20, 25, 50, 75 and 100. Since the price reflects the psychology of the marketplace, these levels offer “natural boundaries or targets.” With resistance and support common along these levels, it makes sense to avoid placing orders right at these values. (If buying on a short term dip in an uptrend, you’d place your order just above an important round number). It also makes sense to place stop loss orders below the round numbers on long positions, rather than exactly on the round number (i.e., $4.90 rather than $5.00).
Duration of Trend
Short term trends are established over a few days. It may be in any direction and has little potential over the long run (except if you’re a daytrader). A strong thrust, however, may indicate the beginning of a move into new ground. Particularly if it crosses a medium or long term trend line. Think of it as an early warning system; a sign to be prepared for a larger move.