Trade Broken Trendlines Without Going Broke

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Trade Broken Trendlines Without Going Broke

One of the simplest methods for technical traders to acquire a fast overview of an asset’s trend or direction is to plot its trendlines onto a chart. At the same time, trendlines may take several shapes and vary in length and importance. In this post, we’ll look at a break of an 11-month trendline and discuss a basic stop-loss method for trading technical signals based on support/resistance breakdowns.

Broken Trendline

A price move through a recognized trendline is one of the most typical indicators of a trend reversal, and this occurred on the NVR Inc. (NVR) stock chart, as seen in Figure 1. While a dip below the trendline is likely to be the first indicator of a trend reversal, volume is frequently critical to monitor since low volume might indicate that the trendline break is not technically significant.

Key Takeaways

  • A broken trendline is a technical indicator indicating a trend shift is imminent.
  • When low volume (rather than high volume) precedes a trendline break, the signal is not as powerful or persuasive.
  • It may be prudent to wait a day or two to ensure if the trendline break is genuine.
  • Risk management, such as stop-loss orders or trailing stops, may assist safeguard gains following a trendline break after a position is launched.

Low volume might be concerning for technical traders since it suggests that bears were not as eager to drive the price significantly down as most expected. Given the low volume and lack of volatility, it is often advisable to wait a few days to ensure that the bulls will be unable to push the stock price above the trendline.

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Figure 1: Trendline break.

Image by Sabrina Jiang © Investopedia2021

In the instance of NVR, the price began to fall, bringing technical proof that the breakdown was legitimate. The bulls attempted to re-enter the market by pushing the price toward the recently created resistance level, but were greeted with a torrent of sellers. The retest of resistance, also known as a flashback, is a typical trading event, and the failed advance higher is generally the last piece of confirmation required by traders trying to benefit from a downturn.

When the dust cleared at the end of July, volatility remained strong, and volume was higher than usual. NVR shares were trading about $600, down from a mid-month high of $723.

The break below the trendline signaled an imminent downward trend and proved to be a successful strategy for those who understood what to watch for.

No Man’s Land

The first step in making a good trade is the unambiguous signal of a stock breaking through a trendline. Taking a profit, on the other hand, is not that simple. When a stock is trading between crucial levels of support and resistance, a trader’s work becomes much more complex since the stock might move either way from a technical standpoint. The trader’s mind is racing with thoughts such, “Should I take a profit when the downward trend stops?” and “Is this merely a consolidation phase before the bears begin to pound the stock lower?”

As the chart below shows, NVR did move downward over the following several months, finishing at $560. It is vital to note that the additional percentage gain from $600 to $550 comes at a much greater cost since the trader knowingly took the risk of giving up a good profit if the stock found unexpected momentum.

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In Figure 2, the stock was trading midway between the lows of May and the highs of March, placing NVR in the center of the range and leaving a trader unclear about the company’s future trajectory. Furthermore, the dropping volume signaled that traders were losing interest. If a trader does not have a specific objective in mind, it may be prudent to close some or all positions at this point and search for a trade with a better possibility of success.

Figure 2: NVR downtrend after trendline break.

Image by Sabrina Jiang © Investopedia2021

A Strategy for Managing Stop Losses

When utilizing trendlines as a foundation for a trade, traders may also consider a strategy. Previous swing highs and lows are a useful sign of prospective regions where the stock’s momentum may be influenced. These are levels where the price has already reversed, and traders often wait for this to happen again.

Many levels of support/resistance can be identified during up and down trends, as shown in Figure 3, 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 because of their historical significance, traders will pay greater attention to levels that have been tested several times (red lines).

Figure 3: Support and resistance levels.

Image by Sabrina Jiang © Investopedia2021

In this case, traders with a larger risk tolerance or a longer investing horizon may decide to place a stop order above the resistance discovered two levels above the current price. This gives the offered security greater leeway to vary and is utilized to benefit from protracted negative swings. It is crucial to remember that if the stop price is hit, this form of the strategy will result in higher losses, but it may also result in larger winnings.

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The Bottom Line

Traders often consider a price dip below a trendline as an indication of a reversal in the current trend. When establishing a strategic entry price, a clear move below a trendline is generally a solid signal. It is sometimes enough to apply a modest risk management plan to safeguard the profits achieved from an increase in momentum that follows a break through a trendline.

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