Trendlines and channels

Evening is coming and you want to check whether your coffee cup sits straight on the table. You put a ruler against it, look, and it is straight. But had you first set the ruler and only then nudged the cup, the result would have looked just as good. Trendlines work in a similar way: it is easy to draw a line that "fits perfectly" if you know how the chart ended. This lesson teaches how to draw lines honestly.

What you will learn

• how to draw a trendline and when to consider it confirmed,
• how to build a channel from it and what it can be used for,
• why use a logarithmic scale and why two lines on a chart is the maximum.

How to draw a trendline

In an uptrend the line connects successive lows, in a downtrend successive highs. It is the same structure you met in lesson 1, turned into a straight line.

• Two points are enough to draw a line, but they prove nothing yet. Two points always lie on some straight line.
• The third point is the first test. When price returns to the line and bounces off it, the line has support. The more bounces, the greater its significance, as long as you did not draw it after the fact.
• Draw the line consistently through wicks or bodies: for example always through wicks. Changing the rule halfway is the classic road to self-deception.

The slope matters. A line that is too steep breaks at the first real breath of the market and says little. A line with a moderate slope, confirmed by many bounces, is worth something.

The channel

Once you have drawn a trendline, try drawing a parallel line through the opposite extremes: in an uptrend through the highs. That makes a channel. In a trend, price often moves between its edges, which gives two practical pieces of information:

• the lower edge is a potential place where the trend looks for support,
• the upper edge is where you can expect a slowdown, so a place to consider taking profits.

Price leaving the channel in either direction is information: a break of the upper edge may mean an acceleration of the trend, and a break of the lower edge is the first warning, as lesson 1 described.

Linear or logarithmic scale

On a linear-scale chart one unit on the vertical axis is always the same amount. When price rises several-fold, such charts distort the picture: the start of the trend looks flat and the end looks steep, although in percentage terms the pace may have been constant. A logarithmic scale shows the same distances for the same percentage changes: a move from 10 to 20 looks the same as from 100 to 200.

A practical rule: for long rallies, weekly and monthly charts and stocks that changed price a lot, use a logarithmic scale. For short-term daily charts a linear scale is usually enough.

Chart example: Nvidia (NVDA), weekly chart on a log scale

In recent years Nvidia went through one of the strongest uptrends in the market: price rose several-fold in a short time. It is ideal material for this lesson, because on a linear scale the chart looks like a rocket launch, while on a logarithmic one you can see an orderly, though violent, trend with pullbacks.

Open the weekly chart of Nvidia and switch the scale from linear to logarithmic. Draw a trendline through successive lows and a channel through the highs. Notice how the slope of the line changes after the switch and which points of the trend fit well on both scales and which only on one.

Step by step

1. Switch the chart to the weekly timeframe and a logarithmic scale.
2. Find two clear lows in an uptrend (or two highs in a downtrend). Use the same rule as in lesson 1.
3. Draw a line through both points and extend it to the right.
4. Wait for a third point. Until price bounces off the line, treat it as a hypothesis.
5. Only then add a parallel line through the highest high between the points, and you have a channel.
6. Write down the date, the drawing rule (wicks or bodies) and the scale, so that in a few weeks you can honestly judge how the line held up.

When price breaks the line, do not do anything rash. Wait for the session (or week) to close outside the line and check whether price returns to test it from the other side, just like with levels in lesson 2. A broken trendline often becomes resistance from which the market bounces.

How it fails

• Drawing after the fact. Any chart can be "described" with a line in hindsight. The real test is to draw the line halfway through history and only then uncover the rest.
• Too many lines. Five lines on a chart are not analysis but decoration. Stick to the rule: at most two lines, the trend and its channel.
• Subjectivity. Several different lines can be drawn through the same lows. Stick to one rule (wicks or bodies) and write it down.
• A break is not the end of a trend. Breaking the line is a warning, not a confirmation. Confirmation comes only from the change in structure described in lesson 1.

Check yourself

1. How many points do you need to draw a trendline and how many to confirm it?
2. Why do we use a logarithmic scale for long rallies?
3. Does a break of a trendline already mean a change in market structure?
4. Why do we recommend at most two lines on a chart?

Next lesson

Lesson 7. Moving averages (SMA and EMA): the oldest tool of the exchange and still the most commonly drawn on charts. You will learn why the "golden cross" so often comes too late and what really hides behind the magic number 200.

Educational material, not investment advice.