Tips on Technicals - Invalidating a Trend Line
As discussed in the "Technician's License" chapter, 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 on an 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 requiring that prices break out at approximately 2/3 of the triangle length (see figure 1). The chart of Gold below shows that the pattern was broken well past the 2/3 mark near the convergence of the upper and lower boundary lines. This was not a valid signal. Breakouts must be due to price movement, not the passage of time. With the latter occurring simply because the triangle ran out of room, a new pattern needs to be applied. Horizontal action was the result here.
Note that the lower boundary was still a valid supporting trend line. One year later, the market did fall back to it to find support.
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. 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.
The US Dollar/ Canadian Dollar rate (figure 2 -- hourly data) shows at least seven occasions where prices rallied to the medium-term trend line without breaking through. On 27 March, 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 28 March 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).
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.
