• Two important powers of the humble trend line
• The collapse of a wonder-stock
• PLUS: How reading your charts can protect you
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OK, now talking of trends – let’s get to the charts. Because as you know, we can visualise trends by looking at price action on our charts…
We often talk about how important the humble trend line can be.
It shows us the major trend for one thing. And once you know the trend, you have a great roadmap for potential trades.
For another, when it’s broken, it warns us that a change of trend is probable. That’s important for two reasons.
First, if you’re already trading with the trend – because you can be prepared to exit your position and preserve capital.
And second, if you’re looking for a new trend – because you can prepare to enter trades that will benefit from that new trend.
Take a look at this long-term chart of the US S&P 500 index from a few years ago as a great example:
Source: IG.com
See what happened after that trend line was broken – and how the price failed to get back above it.
So we had a long and strong uptrend in place from 2002/2003 all the way up to the end of 2007.
Then in January 2008, price broke down through the trend line. It tried to get back up above a couple of time, as buyers jumped in. But the trend line now acted as strong ‘resistance’, price failed to break back up.
Then look what happened. As the sellers gained control, the price slumped some 48% over the following six months.
That trend line break was a warning sign to close long positions. And a heads-up for a powerful new trend.
OK, so this is an extreme example.
But it illustrates the point about trend lines and why, despite being so simple, they can be so powerful.
Let’s take another look at how long-term trend lines can warn you that a big move may be just around the corner.
This is a chart of the share price of wonder-stock ASOS. This thing went up 163% from January 2013 until the end of the first quarter of 2014 (it was up over 20,000% since its IPO in 2001 – hence the label wonder-stock!)
Check out what happened next!
Source: IG.com
Take a look at the trend line connecting the low of May 2013 with the low in October 2013 and extending out to the right.
The trend shown is a powerful one – it built up over the course of 18 months. It takes time and a big effort on the part of investors to reverse established trends in share prices. The longer a trend has gone on – the harder investors have to work to reverse it.
You can see this in action on the trend line. There was a big sell-off in January 2014.
But, you can also see that this sell-off was halted by our trend line as buyers came in. The long-term upwards direction of the shares withstood the assault by the sellers. ASOS shares stopped falling and moved back up for a few weeks.
But – as you can see – bearish sentiment won out in the end. The sellers were not to be overcome – even by such a strong uptrend. In March 2014, ASOS shares broke below the trend line.
As we saw before in the S&P chart, the breaking of such an important trend line gives you a severe warning. It tells you that you may see a major change in the direction of a share price.
If you had been holding ASOS shares, you would have been able to react and sell – locking in their gains. Or you could have sold short and made a superb profit.
However, you could have also had an advance warning of a change in long-term trend. Look at the trend line running parallel to the first one, beginning at the highs made in January 2013, to see how.
Using a parallel line to look for trend change clues
Can you see how this upper trend line ‘contains’ all the peaks that followed the January 2013 high? ASOS shares hit a new high in January 2014 – but that high did not breach our upper trend line.
Most importantly, the new highs that ASOS hit in March 2014 fell quite a way short of this upper parallel line.
So, while you could see that the upward trend was continuing (using your lower trend line), you could also see (from your upper trend line) that it could well be running out of steam.
By using parallel trend lines to create a trend channel, therefore, you could have given yourself an early warning of a weakening in ASOS’s upward momentum, and then spotted an outright ‘sell’ signal.
Understanding the charts would have protected you from the rapid falls that came once the long-term trend had been reversed, or given you a very welcome signal that it was time to sell short.
Make sense?
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The post When the line breaks, watch out! appeared first on The Daily Reckoning - UK Edition.