Plotting trendlines onto a chart is one of the easiest ways for technical traders to get a quick idea of an asset's direction.
As you may know, trendlines come in a variety of different forms and they can greatly vary in length and significance. In this article, we'll take a look at an 11-month trendline that we identified on the chart of NVR Inc. (NYSE: NVR) in our June 12, 2007 ChartAdvisor newsletter, and we'll show how it affected the short-term direction of the stock's price. We'll also cover a simple stop-loss strategy that may be used when trading technical signals based on breaks of support/resistance.
What We Saw
A price move through an identified trendline is one of the most common signals of a trend reversal and, as you can see in Figure 1 below, this was exactly what happened on the chart of June 12 NVR chart. We noted that the drop below the trendline would likely be the first signal of a reversal in the trend, but also that it was important to pay attention to the lower-than-average volume because it could signal a failed break. The low volume was a concern for technical traders because it was showing that the bears were not as interested in pushing the price sharply lower as most were expecting. Given the low volume and lack of volatility, we argued that it would be a good idea to wait several days to confirm that the bulls wouldn't be able to send the stock price back above the trendline. (For related reading, see Market Reversals And How To Spot Them.)
In the case of NVR, the price started to move lower and with this came technical confirmation that the breakdown was valid. The bulls tried to step back in by pushing the price toward the newly formed resistance level, but this attempt was met with a flood of sellers. The retest of the resistance, also known as a throwback, is a common occurrence in trading and the failed move higher is usually the final piece of confirmation needed by traders looking to profit from a pullback. (For more insight, read Trading Failed Breaks.)
When the dust settled near the end of July, volatility remained high and volume was trading at higher-than-average levels. NVR shares were hovering around the $600 mark - falling from a mid-month high of $723.
The break below the trendline was a good indication of the impending downward momentum and proved to be a profitable strategy for those who knew what to look for. (To learn more about how incorporate this tool into your strategy, see Tracking Stock Prices With Trendlines.)
No Man's Land
The clear signal of a stock breaking through a trendline is the first step to making a highly profitable trade. However, the act of taking a profit is not quite as easy. A trader's job becomes substantially more difficult when a stock is trading midway between influential levels of support and resistance because, from a technical perspective, the stock could go either way. The questions in the trader's mind come quickly: "Should I take a profit when the downward momentum lets up?" and "Is this just a period of consolidation before the bears continue to hammer the stock lower?"
As you can see from the chart below, NVR did trend lower for the next couple of months, ending near $560. It is important to mention that the extra percentage gain from $600 to $550 comes at a substantially higher cost because the trader consciously ran the risk of giving up a healthy gain in the event that the stock was able to find some unexpected strength. Notice how in Figure 2 the stock was trading halfway between the March 2007 high and the May low from 2006. This can leave a trader uncertain about the future direction. In addition, the declining volume again suggested that traders were losing interest. If a trader does not have a defined target, it may be a wise decision to close some or all of the position at a junction like this and to look for a trade with a higher probability of success.
A Strategy for Managing Stop Losses
There is also a strategy that traders can consider when using trendlines as a basis for a trade. Previous swing highs/lows are a good indicator of potential areas that may influence the stock's momentum. These are levels where the price has reversed in the past and traders will often look for this situation to occur again. As you can see in Figure 3 below, there can often be many levels of support/resistance 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 the order behind the price as it breaks below the lower price levels. Keep in mind that traders will pay more attention to levels that have been tested several times (red lines) because of their historical influence.
In this example, traders with a higher level of risk aversion, or those with a long-term investment horizon, may instead prefer to trail a stop order above the resistance found two levels above the current price. This would allow the given security to have more room to fluctuate and is used to profit from prolonged downward moves. It is important to note that this version of the strategy will lead to larger losses if the stop price is reached, but can also lead to larger gains.
What We Learned
A drop below a trendline is often used by traders as a signal of a reversal in the current trend. The clear move below a trendline is often a good indicator for determining a strategic entry price. Sometimes it only takes the implementation of a simple risk-management strategy to protect the gains made from an uptake in momentum that accompanies a breakdown through a trendline.