Most of us know about trendlines at a basic level. But let me describe how I look at them so we’re all on the same page.
Trendlines are straight lines drawn between two or more points – although typically it’s only two points.
Drawing these lines defines a range for a stock, a support level, or resistance.
You can have multiple trendlines on a chart at the same time.
Usually, I connect them using the lowest or highest points on candlesticks.
Here’s how it might look on Restoration Hardware (RH).
RH Hourly Chart
Here, I drew the trendline using the two points the arrows identify. You can see how the next time it ran into that trendline, price was swiftly rejected lower.
Interpreting trendline breaks
Trendlines hold for only so long. Eventually, price shifts in the other direction, whether immediately or over time.
The strong the trendline, the harder the break tends to be.
Here’s an example of one in Tesla (TSLA) intraday.
TSLA Hourly Chart
In this chart, I drew two trendlines. One stretches a little longer than the other. However, they both converge at the same point.
When Tesla shares closed below both of those lines, sellers swiftly stepped in, sending shares plummeting in a matter of minutes.
That’s the kind of move that happens when a trendline breaks.
Here’s another example with Inovio Pharmaceuticals (INO)
INO Hourly Chart
After an explosive move, INO began to lose momentum. Slowly, it started moving sideways.
In that process, it tried to sell off a couple of times. When it did that, it created the swing points needed to establish a trendline.
Once shares finally broke that trendline, the jig was up. After a brief rally, shares rolled over and headed lower.
Turning this into a trade
Here’s where the fun begins.
Quite often, when a stock breaks a trendline, it will come back up to retest at or near that trendline or breakdown area.
I use that to create better entry prices for myself. All of my trading balances the risks (potential losses) and rewards. By waiting for a retracement, I put my entry closer to my stop out, lowering my total risk.
Using these trendlines, there’s two ways I would use stops. First, any close back above the trendline could act as a stop.
Second, a close back above the highs would also work if they’re available like with TSLA or INO.
What both of these identify is where the reversal failed.
Next, I need to establish targets. The way I do that is looking for support or resistance levels.
Typically, I rely on the 8 and 21-period exponential moving averages on larger timeframes, Fibonacci retracement levels, consolidation areas, or other places of significance.
Before I make the trade, I ensure that the potential reward is enough to justify the risk. If the targets are too close to the entry, I won’t make enough money compared to possible losses.
Lastly, as an options trader, I always like to scale out of my trades. When I hit my first target, I’ll take a portion of the trade off. Then, I leave the remainder on with a stop moved up to breakeven.
This is kind of like dollar-cost-averaging. I don’t always know how far the stock will run. So this effectively hedges my bets.
One final thought – this strategy isn’t tied to a specific stock or timeframe. I’ve used it on everything from the SPY to individual equities.
I find that it works best when combined with other analysis components that lead to the same conclusion.
Learn all about my TPS setup
Now, you’ve heard me talk about my infamous TPS setup before. But are you ready to learn it?
Check out my upcoming LottoX webinar where I lay out how I use it to craft short-duration trades using options.