- 2002: Volume 11, No. 2 Chartist Corner: Invalidating a Trend Line

As we discussed in "Technician's License" (March/April 1996 Trader), prices can briefly penetrate the boundaries of technical patterns without invalidating them. Usually when this happens, prices snap back within in a period or two. Volume studies augmented by momentum and directional indicators help determine whether the violation was significant. When a lightly tested trend line or pattern boundary is violated without any real market conviction, it may become necessary to adjust the trend line or boundary to include the new data.

Time Breaks
When a technical pattern, such as a triangle, breaks, prices begin to trend in the direction of the break. The typical conditions for a valid break are a significant price move and increase in volume. A significant price move is one that is relative to the specific market and not just a few ticks. Triangles have another condition and that is that the prices break out at approximately 2/3 of the triangle length (see Figure 1). The gold chart below shows that the pattern was broken close to the convergence of the upper and lower boundary lines. Breakouts must be due to price movement, not the passage of time, with the latter occurring simply because the triangle ran out of room.

Figure 1:

Now that the triangle is invalid, the remaining unbroken trend line may gain added significance. In the case of gold, the lower boundary was still a valid supporting trend line. However, if a triangle pattern occurs in isolation and not as part of a longer term formation or trend, both boundaries must be ignored.

Changing a Line
The more a trend line is touched by prices, the stronger it becomes and the more significant a break through it will be. Small violations of the trend line may simply mean that the original line was set too tight and should be adjusted to include the new data. On occasion, a shorter term trend line in one direction holds power in the market over a longer term trend line in the opposite direction. Unless trading activity picks up at that juncture, the longer term trend line may need to be adjusted, even if it appeared to be strong due to several market touches.

Figure 2:

The U.S. Dollar/Canadian dollar cross (Figure 2-hourly data) shows at least seven occasions where prices rallied to the medium term trend line without breaking through. On March 27, prices finally moved above the line, supported by the short-term rising trend line. Volume was light on that day and trading over the next two days was more sideways than trending. The medium term trend line was adjusted to capture March 28 trading. On the next day, the market proved this strategy correct as it plummeted from the trend line to break the short-term trend and establish new lows (Figure 3).

Figure 3:

Art and Science
While quantitative methods have their place in technical analysis, trader experience and judgment still play a key role. As long as greed and fear rule the markets, rules for trend line and pattern construction can be broken, at least temporarily, without changing the outcome of a trading decision.

Michael N. Kahn is a columnist for Barron's Online based out of Florida. He also writes a free technical newsletter. To subscribe to this service, please visit www.midnighttrader.com. The complete collection of Michael Kahn's "Tips on Technicals" is available in Real World Technical Analysis.