Q: Could you explain about drawing trendlines? Sometimes you seem to draw them through the price action, rather than below or above.

A: As with much in technical analysis, drawing trendlines involves a good bit of art mixed in with some science. A trendline drawn through price action (a low, high or even close) would be classified as an internal trendline. Some technicians prefer to match the exact highs (or lows) when drawing trendlines, while others prefer closing prices only. Personally, I look for the line of best fit, which usually means drawing through a few bars or candlesticks along the way.

The validity of a trendline depends on the robustness of the reaction lows (or reaction highs) used to draw it and the number of touches. A low formed with one long spike would be less robust than a low formed with a 3-5 day consolidation. Therefore, I try to look for price clusters (when possible) to draw trendlines and try to avoid intraday lows (or highs) that appear extreme. It takes two points or touches to draw a trendline, but three to make it robust.

In addition to price clusters and touches, I also consider the slope. Trendlines that are too steep are unlikely to hold. Trendlines that are not steep enough will likely be broken too late. Ideally, I would look for trendlines that are about 45 degrees.

The weekly chart of UTX features an internal trendline with a slope around 45 degrees. The trendline started from a support zone established over a 6-week period that was accented with a weekly bullish engulfing pattern in early March. The trendline is drawn as a "line of best fit" and cuts through the summer and autumn lows.

The slope of the trendline depends on the type of scale used on the price chart. On a linear scale, a price advance from 10 to 20 would look the same as an advance from 100 to 110, even though the percentage change is quite different. However, on a semi-log scale, a price advance from 10 to 20 would reflect a 100% increase and an advance from 100 to 110 a 10% advance. The advance from 10 to 20 would appear much greater than the move from 100 to 110. This difference in scaling will also affect trendlines and their slopes. On a linear scale, a trendline is simply a line that connects peaks or troughs to reflect the absolute rate-of-change. On a semi-log scale, the slope of a trendline more accurately reflects the percentage rate-of-change for prices over a period of time. The steeper the trendline, the higher the percentage rate-of-change. Because I use semi-log scales, my trendlines are used to gauge the rate-of-change. A break below an up trendline signals that the rate of ascent is slowing and a break above a down trendline signals that the rate of descent is slowing. Both trendline breaks serve as an alert that the trend may be about to change.

Long-term investors usually prefer trendlines based on semi-log scales and short-term traders seem to like trendlines based on linear scaling.

For more on trendlines, see this Chart School article.

Hope this helps.
Cheers, Arthur Hill

Q: Ken, do you suggest that if a stock is below its 200 day moving average, that it should not be bought? Also, do you wait for the price to exceed its recent high? Is it ok to buy when the CCI and stochastics are at highs, or wait?

A: I don't know if I would use not buying a stock under its 200 day moving average as a rule. The more important point is that 200-day moving averages tend to be a significant resistance line if the stock is below it. Further, I like to look at the 50 and 200 day together -- the crossing action is like a super stochastic. If the 50 day crosses above the 200 the medium to longer term picture is decent, while the opposite is true if the 50 day crosses below the 200. Look at these plotted over the Nasdaq 100 for example. As soon as the 50 day average crossed below the 200, the picture never really recovered. Also, look for levels in stocks where averages meet together, with themselves or with trendlines. These will be significant areas of resistance or support that are unlikely to break.

About stochastics and CCI, it's okay to buy when they are high. For example, stoch readings in a sharp rally can stay up high for some time. But I prefer to see them mid range and not too overextended before jumping in. Remember, all the stoch does is measure the closing price relative to the prior period you select, so in a runaway bull or bear move, they can stay at the extreme points for a while.

Ken Mitchell