December 3rd, 2005

Do Trend Lines Work?

A trend line connects two, and preferably more, approximate inflection points (also sometimes called “pivot points”), over a period of time, in a stock’s price chart. But what are trend lines and how are they constructed?

Inflection points are relevant because they indicate the prices where there a shift has taken place in the balance between relative willingness of buyers and sellers to execute transactions. These reversals may be caused by a significant event (such as either internal to the company as reflected in their financials, within the industry or for the economy as a whole (such as interest rates, exchange rates, wars) or merely by the temporary absorption of the supply of either
available buyers or sellers.

Some key points to note in this definition are:

  1. What’s true in physics (Galileo Law of Inertia: Every object in a state of uniform motion tends to remain in that state of motion unless an external force is applied to it.) is also true in stocks. A stock’s price at a point in time is the instantaneous snapshot
    (expressed as a transaction in a number of shares at a given price) of the balance between a buyer’s and seller’s forces. But there’s a continuous flow of buy and sell orders and therefore the relative influence of buyers and sellers in executing transactions is continually in flux. An inflection point is where the prevailing balance between buy and sell orders forces the stock’s price to move either up or down to complete the next trade.
  2. What is the most relevant time horizon? When we can zoom in or out on a stock’s price chart, we can see inflection points occurring every minute (an “up-ticks” or “down-ticks” is when a trade is at a higher or lower price than the previous), hour, day (closing higher or lower than previous day), week, month, etc. For an example of graphs over various time horizons see my analysis of Allied Capital. The relevant inflection point coincides with the investor’s preferred time horizon (e.g., day traders prefer “-ticks”; swing traders prefer days). A corollary is that the extent and length of price movements (i.e.,
    the time between successive inflection points) will be directly proportional to the length of the time horizon.

  3. Trend lines can have almost any direction; they may be horizontal, upward sloping or downward sloping. The slope merely reflects the direction of the prevailing trend of supply and demand balance. If successive inflection points are continually higher,
    the trend line will be upward sloping indicating continually growing demand; successively
    lower inflection points indicating decreasing demand.
  4. Is drawing a trend line precise? Since the attitudes of buyers and sellers, as reflected in their order flow, changes over time, it’s difficult pinpointing a single true inflection point. A stock’s price may either overshoot or undershoot the trend line, but only by small percentages.

While inflection points don’t have “memories”, the buyers and sellers who conducted transactions close those prices do and they may, in the future, as the price approaches those prior transaction prices, either want to reverse or reinforce through additional transactions. For example, buyers who purchased and subsequently only saw the price fall may want to cut their losses as the price approaches their purchase price; sellers who sold only to find the price rise after their sale may want to reestablish their position as the prices retreat to close to the price they sold. Therefore, while drawing a line between two points doesn’t prove much of anything, a straight line connecting 3 or more points proves, to me at least, to be more than a random occurrence. And the more points forming that line, the more significantly meaningful that line becomes. See, for example, the 1989-2005 chart of Burlington Resources (BR), one of the star performers in the recent energy bull market:

The stock had 7 inflection points around 25-26 over 15 years before it broke through on the eighth attempt at the beginning of 2004 (BR also had 9 inflection points at the lower trend line of its trading range at 15-16). One could argue that BR’s failure to break through either of these trend lines 7-9 times proves that a trading strategy on likelihood of that occurring is a flawed
strategy. On the contrary, I believe it’s better to view this trading pattern as a continually ever tighter wound spring …. eventually it has to burst. BR’s more than 300% move is the result of it’s being trapped in the trading range. We don’t care why the range was set for so long as the prices it was or the reasons for it’s ultimately breaking though and moving to higher levels. We’ll let the fundamental analysts provide the explanations after the fact, we’re only in interested in finding enough situations like this and taking advantage of them.

The long-term BR chart offers a perfect example of the use of trend lines as “resistance” and “support” levels in a trading strategy. The upper boundary trend line (at 25-26) was the resistance level while the lower boundary trend line (at 15-16) was the support level. Once a break through of either (defined as approximately 5-10% accompanied by substantially higher
average trading volume) has occurred, the price will reverse direction and the broken trend line will be tested in it’s mirror image role (resistance should become support, support should become resistance). If the test fails, a true breakthrough hasn’t occurred. If the test holds, there’s a high probability that the stock will extend the move in the direction of the breakthrough.

Let’s see how trend lines can work by applying the above to several of this week’s additions to the Investors Business Daily 100 (IBD100):

  • Varian (VAR) – the converging trendlines form a consolidation pennant out of which there was a breakout with a gapping 13% move up on October 18 followed by another 6% move the next day. VAR on a watchlist, if acted on, would have captured most of the 11 point move since then. I believe it’s too late to get on this moving train now.
  • Radvision (RVSN) – Another pennant pattern with a relatively recent breakthrough. As further confirmation of likely further upward movement, there is another trendline that at 15 that extends back to 2000. (Chart)
  • Aluminum Corp of China (ACH) – Just breakthrough an 18-month pennant consolidation pattern with 7 total inflection points; 4 attempts to penetrate the resistance level and 3 at the resistance level. Another horizontal trend line has been drawn at the previous all-time high alerting for a potential future resistance level. The exact slope of that resistance line will be determined when a new inflection point is begun. (Chart)
  • Napco Security Systems (NSSC) – An upward sloping triangle with 4 attempts to breakthrough resistance, the final being successful and 3 passes at the bullish, upward-sloping support trendline. There is a high probability of a retracement of the breakthrough and testing of the resistance as a support. (Chart)
  • Select Comfort Corp (SCSS) – Another pennant pattern with 5 attempts to breakthrough the resistance trendline, the final being successful, and 3 passes at the support level. Here too, the breakthrough is relatively new and there may soon be a testing. (Chart)

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