Trade Broken Trendlines Without Going Broke

Plotting a security’s trendlines onto a chart is one of the easiest ways for technical traders to get a quick idea of an asset’s trend or direction. At the same time, trendlines can come in a variety of forms, and they can vary in length and significance. In this article, we’ll take a look at a break of an 11-month trendline and cover a simple stop-loss strategy that can be used when trading technical signals based on breaks of support/resistance.

Broken Trendline

A price move through an identified trendline is one of the most common signals of a trend reversal, and as you can see in Figure 1 below, this happened on the NVR Inc. (NVR) stock chart. While the drop below the trendline would likely be the first signal of a reversal in the trend, it is often important to pay attention to volume because low volume can signal that the trendline break is not technically significant.

Key Takeaways

• A broken trendline is a technical signal that can suggest a change in trend is at hand.
• If low volume (rather than high volume) accompanies the break of a trendline, the signal is not as strong or convincing.
• It can make sense to wait a day or two to make sure that the trendline break is legitimate.
• Once a position is opened, risk management—in the form of stop-loss orders or trailing stops—can help protect profits after a trendline break.

Low volume is sometimes a concern for technical traders because it can suggest that bears were not as interested in pushing the price sharply lower as most were expecting. Given the low volume and lack of volatility, the best move is sometimes to wait several days to confirm that the bulls will not be able to send the stock price back above the trendline.

In the case of NVR, the price started to move lower, and with this came technical confirmation that the breakdown was valid. The bulls tried to step back in by pushing the price toward the newly formed resistance level, but this attempt was met with a flood of sellers. The retest of the resistance, also known as a throwback, is a common occurrence in trading, and the failed move higher is usually the final piece of confirmation needed by traders looking to profit from a pullback.

When the dust settled near the end of July, volatility remained high, and volume was trading at higher-than-average levels. NVR shares were hovering around the $600 mark, falling from a mid-month high of $723.

The break below the trendline was a good indication of the impending downward momentum and proved to be a profitable strategy for those who knew what to look for.

No Man’s Land

The clear signal of a stock breaking through a trendline is the first step to making a profitable trade. However, the act of taking a profit is not quite as easy. A trader’s job becomes substantially more difficult when a stock is trading midway between influential levels of support and resistance because, from a technical perspective, the stock could go either way. The questions in the trader’s mind come quickly: “Should I take a profit when the downward momentum lets up?” and “Is this just a period of consolidation before the bears continue to hammer the stock lower?”

As you can see from the chart below, NVR did trend lower for the next couple of months, ending near $560. It is important to mention that the extra percentage gain from $600 to $550 comes at a substantially higher cost because the trader consciously ran the risk of giving up a healthy gain in the event that the stock was able to find some unexpected strength.

Notice how in Figure 2, the stock was trading halfway between the May lows and March highs, putting NVR in the middle of the range and leaving a trader uncertain about the future direction. In addition, the declining volume again suggested that traders were losing interest. If a trader does not have a defined target, it may be a wise decision to close some or all of the positions at a junction like this and to look for a trade with a higher probability of success.

A Strategy for Managing Stop Losses

There is also a strategy that traders can consider when using trendlines as a basis for a trade. Previous swing highs/lows are a good indicator of potential areas that may influence the stock’s momentum. These are levels where the price has reversed in the past, and traders will often look for this situation to occur again.

As you can see in Figure 3, many levels of support/resistance can be identified during the up and down trends, and one strategy would be to set a stop-loss order above the previous level of resistance (in the case of a short position) and trail a stop order behind the price as it breaks below the lower price levels. Keep in mind that traders will pay more attention to levels that have been tested several times (red lines) because of their historical influence.

In this example, traders with a higher level of risk aversion, or those with a long-term investment horizon, may instead prefer to trail a stop order above the resistance found two levels above the current price. This would allow the given security to have more room to fluctuate and is used to profit from prolonged downward moves. It is important to note that this version of the strategy will lead to larger losses if the stop price is reached, but can also lead to larger gains.

The Bottom Line

A price that drops below a trendline is often used by traders as a signal of a reversal in the current trend. The clear move below a trendline is often a good indicator for determining a strategic entry price. Sometimes it only takes the implementation of a simple risk management strategy to protect the gains made from an uptake in momentum that accompanies a breakdown through a trendline.

Read the original article on Investopedia.